Prepayment Penalty: What It Is And How To Avoid It
Miranda Crace8-Minute Read
July 03, 2022
For many homeowners, the concept of a “prepayment penalty” is odd. Why should you be penalized for paying a loan early?
Well, that’s the thing about mortgage loans: Many of them surprisingly come with prepayment penalties, which limit your flexibility and can take a bite out of your wallet – just for trying to do the right thing for your finances. There’s a good reason why lenders might not want you to pay the mortgage off early, and we’ll get to that soon.
When you’re looking at home loans and deciding what type of mortgage is best for you, you should watch for prepayment penalties. They’re sometimes hidden in mortgage contracts, which can make them easy to overlook.. By learning about penalties now, you can approach your mortgage search and eventual contract armed with more knowledge and strategies for finding the best mortgage lender to fit your needs.
It’s important to note that Rocket Mortgage® does not have any prepayment penalties.
What Is A Prepayment Penalty?
A mortgage prepayment penalty is a fee that some lenders charge when you pay all or part of your mortgage loan off early. The penalty fee is an incentive for borrowers to pay back their principal slowly over a longer term, allowing mortgage lenders to collect interest.
Note that it doesn’t normally kick in when you make a few extra payments here and there to pay your principal off sooner, or make principal-only payments. Most mortgage lenders allow borrowers to pay off up to 20% of the loan balance each year. Instead, a mortgage prepayment penalty typically applies in situations such as refinancing, selling or otherwise paying off large amounts of a loan.
Why Do Lenders Charge A Mortgage Prepayment Penalty?
Typically, you might think a person or organization that loans money wants it repaid as soon as possible. But here is why mortgage lenders don’t.
The first few years of a loan term are riskier for the lender than the borrower. That’s because most borrowers haven’t put down a significant amount of money when compared to the value of the house. That’s why lenders charge you “interest,” which is protection from a financial loss. If you pay the loan off right away, they lose out on all those interest fees which were included in the loan as an incentive to them to give you, the borrower, a loan.
That’s why many lenders include the mortgage penalty in the first place – they offer it as a way to market lower interest rates, knowing that they will make up the difference over the life of the loan, or in receiving a prepayment penalty should you pay off the mortgage before they have recouped their costs.
How Much Will I Pay?
As might be expected, prepayment penalty costs vary. However, there are some typical models for determining penalty cost:
- Percentage of remaining loan balance: Here they assign a small percentage, such as 2%, of the outstanding principal as a penalty fee if the payoff is made within the first 2 or 3 years of the loan term.
- X number of months’ interest: Here you just pay a total of a certain number of months interest, such as 6 months.
- Fixed amount: With this, the lender writes in a set figure, such as $3,000, for paying off a loan within the first year. This is not typically used in mortgages.
- Sliding scale based on mortgage length: This is the most common model. Let’s use a sequential 2/1 prepayment penalty over the first 2 years of the loan as an example. If the mortgage is paid off during year 1, the penalty is 2% of the outstanding principal balance. If the mortgage is paid off during year 2, then the penalty is 1% of the outstanding principal balance.
Want to have some fun with math? Here’s how it looks when we use a model of a typical mortgage and interest rate. We used a hypothetical $200,000 loan.
- Percentage of remaining balance: If the loan is paid in full during the first 2 years of the note, the penalty is $3,600 if you had 10% equity prior to the payoff ($180,000 x 2%).
- X number of months’ interest: If the loan is paid in full during the first 2 years of the note, the penalty is $5,000 ($200,000 x .05= $10,000/12 months = 833.33 x 6 months penalty amount = $5,000 penalty).
- Fixed amount: You would pay whatever the stated fixed amount is, such as $3,000.
- Sliding scale based on mortgage length: On a $200,000 loan amount, the mortgage penalty would be $4,000 if paid off during year 1 of the note, with a $2,000 penalty if paid off during year 2 of the note.
Interpreting Your Mortgage Contract
As with any financial contract, you should read the fine print. In this case, you’ll want to find out if there is a prepayment penalty clause in your mortgage contract and how to interpret the consequences of triggering the fee.
How Do I Check For A Prepayment Clause?
The good news is that the law requires lenders to disclose prepayment penalties, along with monthly fees and other loan details. As mentioned, you’ll want to read the “fine print” – in this case, the loan estimate or the paperwork that you’ll sign at closing, where you’ll find it mentioned prominently in the addendums and/or disclosure documents with all the other terms of your mortgage loan.
It’s perfectly fine to ask your lender if they charge a prepayment penalty; if they do, ask them to show where in the paperwork you would find the details. If you already have a loan, you can look at your monthly billing statement, as it should be outlined in there.
There are some instances where prepayment penalties are illegal. These include:
- Federal Housing Administration (FHA) loans
- Department of Veterans Affairs (VA) loans
- United States Department of Agriculture (USDA) loans
- Student loans or personal loans (It’s true that these loans aren’t mortgages, but it’s still good bonus info to know.)
Learn What Will And Won’t Trigger The Loan Prepayment Fee
As we mentioned, making a few extra payments is not going to cause the prepayment penalty fee to kick in. But there are other times that you should be aware of when it will.
First, it’s important to know that there are two different kinds of prepayment penalties:
- A soft prepay penalty allows you to sell your home without invoking the penalty, so it would apply if you refinanced or just paid off a big chunk during the early years of the loan.
- A hard prepay penalty would apply in the above circumstances, plus if you sold the home.
Penalties usually cover the first few years of a loan, because, as we mentioned, those are the riskiest for the lender. So if you refinance early on, you’ll trigger the prepayment penalty. The amount of the fee will differ based on the type of mortgage penalty fee you have. See the above models for an example of what that could be.
As you’re reading through your Loan Estimate and contract, be aware of the type of prepayment penalty that comes with your loan, just in case something happens and you decide to refinance and/or sell. If you’re unsure, ask your mortgage lender before signing the papers and ask them to walk you through the math as it applies to your type of prepayment penalty, your loan amount, your amortization and your interest rate.
What To Do With A Prepayment Clause
Does the thought of one more fee give you pause? It should – after all, no one wants to pay for something extra, especially when they think they are doing something that’s smart for their financial situation. Here are some things to consider before signing:
Run All The Numbers
Even if you don’t think you’re going to ever trigger the penalty, it’s a good idea to know the costs, just in case. In fact, it might make the difference between choosing a loan with a prepayment penalty and one without, if the costs are egregious.
Find out the type of prepayment penalty that comes with your mortgage and compare the cost of staying in your current loan past the penalty date with the cost of paying it off early and invoking the penalty. Each home buyer must consider which route feels best for their personal financial situation.
Should I Sign?
While anything can happen and you can never be 100% certain you won’t sell or refinance your house, these questions can help you determine the likelihood, i.e. how worried you should be about a potential prepayment penalty:
- Are you planning on selling or refinancing your home relatively soon?
- If you know you’re going to be in one place for a length of time (as far as anyone can be certain, of course), the penalty might not ever affect you.
- And if you already have a rock-bottom interest rate, you’re unlikely to be refinancing.
- How important is it to you to have the ability to pay early?
- If having long-term debt and the associated monthly payments is too anxiety-inducing, you might want to consider mortgage lenders who don’t charge a prepayment penalty, just in case you come into a windfall and want to pay it all off. You might also choose to refinance your mortgage in the future to consolidate debt. Just remember you also will miss out on the mortgage interest deduction if you do so, so again, it’s important to weigh all financial factors.
Prepare To Negotiate
If you decide to stick with your lender and the mortgage with the penalty, you can try to negotiate a lower fee. After all, even if you plan on staying in your new home for many years, it may be worth it to try negotiating to mitigate your risks in case something changes.
You can always try to negotiate having it removed from the contract; ask your lender if they will waive the fee. If they agree (which is unlikely but always worth a try), make sure you have it in writing. You can also ask your lender for a quote without the penalty, but remember that might increase your interest rate.
And finally, you can look for mortgage lenders that don’t use mortgage prepayment penalties, since that’s one less thing to worry about over the long run.
Skip The Fees: How To Avoid A Prepayment Penalty
In fact, that might be your best bet for reducing your anxiety and math angst: Remember that there are other alternatives to accepting a prepayment penalty. Yes, you can try negotiating it down, but the best way to avoid the fee altogether is to switch to a different loan or a different lender.
Since not all lenders charge the same prepayment penalty, make sure to get quotes from different lenders to find the best loan for you.
Alternatively, look for those lenders who don’t ever charge prepayment penalties, such as Rocket Mortgage.
Prepayment Penalty FAQs
Does prepaying a loan affect your credit score?
It’s well-known that canceling credit cards can impact your credit score. That’s because, for every account you close, you also have less credit available to you.
However, prepaying your mortgage shouldn’t have a significant impact on your credit score. This shouldn’t be a major factor in deciding whether to pay your mortgage off early.
How do I find out if my mortgage has a penalty for paying it off early?
The best way is to ask your lender or potential lender. They’re required by law to disclose these terms. Have them point out the fine print in the contract that covers prepayment penalties. It should also be prominently featured in your loan estimate and closing disclosure.
Is it worth paying off my mortgage early?
You’ll have to crunch the numbers on the terms in your mortgage. The further along you are in your mortgage, the more likely it is to work out for you. Earlier on, your best long-term strategy might be to make an extra payment now and then.
The Bottom Line
Before you choose a mortgage, verify whether there’s a penalty for prepayment of your mortgage loan. You should also research lenders like Rocket Mortgage that don’t charge prepayment penalties.
Ready to buy a new home? You can start the preapproval process today.
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