Prepayment Penalty: What It Is And How To Avoid It

When you’re looking at home loans to decide which mortgage is best for you, you should pay attention to prepayment penalties. If your lender charges a prepayment penalty, it’s another fee you may have to pay. By learning about penalties now, you can approach your mortgage search and contract armed with more knowledge and strategies for finding the best mortgage lender to fit your needs.

What Is A Prepayment Penalty?

A mortgage prepayment penalty is a fee some lenders charge when you pay all or part of your mortgage loan off early. The fee is an incentive for borrowers to pay back their principal on schedule for a loan’s entire term, allowing mortgage lenders to collect their planned interest.

Prepayment penalties don’t typically kick in when you make a few extra principal-only payments to pay off your mortgage loan sooner. Some mortgage lenders allow borrowers to make extra payments that add up to 20% of the loan balance for that year. A mortgage prepayment penalty is usually triggered when a homeowner refinances, sells their home or pays off a significant portion of their mortgage loan.

However, not all lenders charge prepayment penalties. Some lenders, like Rocket Mortgage^®, don’t charge prepayment penalties.

Types Of Prepayment Penalties

There are two different types of prepayment penalties:

• Soft prepayment penalty: A soft prepay penalty only applies when you refinance or pay off a big chunk of your mortgage loan during the loan’s early years. You can sell your home without incurring a penalty.
• Hard prepayment penalty: A hard prepay penalty applies to any prepayment: refinancing, paying off a significant portion of your loan or selling the home.

Why Do Lenders Charge A Mortgage Prepayment Penalty?

Prepayment penalties are added to a mortgage contract to protect lenders from the loss of interest payments over the life of the loan.

The first few years of a loan term are riskier for the lender than the borrower. Most borrowers haven’t put down a significant amount of money compared to the value of the house. That’s why lenders charge mortgage interest, which protects them from a financial loss.

If a borrower pays the loan off right away, the lender loses out on all the interest they expected to earn. Interest compensates lenders for the risk of lending money.

Mortgage lenders may include a mortgage penalty to market lower interest rates, expecting that they’ll earn interest over the life of the loan. A lender can charge the prepayment penalty to recover some of the interest they would have earned if the borrower didn’t pay off the loan early.

How Much Is A Prepayment Penalty?

Prepayment penalty costs vary depending on the lender and the loan. Here are some common models lenders use to determine the prepayment penalty’s cost:

• Percentage of the remaining loan balance: The lender will assign a percentage, such as 2% of the outstanding principal, as a penalty fee if the mortgage is paid off within the first 2 or 3 years of the loan term.
• Lender-specified number of months’ interest: The borrower will pay a specified number of months in interest, such as 6 months.
• Fixed amount: While this payment model typically isn’t used for mortgages, a lender may set a flat fee, such as $3,000, for paying off a loan within the first year.
• 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 a 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, the penalty is 1% of the outstanding principal balance.

Before deciding to pay off all or part of a mortgage early, it’s also important to consider the potential impact on your credit score. It may cause a temporary dip in your credit score depending on its impact on your credit mix (types of credit).

Prepayment Penalty Example

To demonstrate how much a prepayment penalty can cost with each payment model, we’ll consider a hypothetical home with a $200,000 mortgage principal and interest rate of 5%.

Percentage Of The Remaining Balance

Let’s assume the penalty is 2% of the remaining balance, and you’ve paid off $20,000 over 5 years. If you fully pay off your mortgage, your lender will charge a prepayment penalty of $3,600. We arrive at this number by multiplying $180,000 (the remaining balance) by 2%, or 0.02.

Lender-Specified Number Of Months’ Interest

If the loan is paid in full during the first 2 years and the prepayment penalty equals 6 months of interest, the penalty will cost around $5,000.

First, multiply the principal balance by the 5% interest rate.

$200,000 ✕ .05 = $10,000

Then, divide the result by 12 to find the monthly interest paid.

$10,000 ∕ 12 months = $833.33

Finally, multiply the result by 6 to calculate the penalty.

$833.33 ✕ 6 months’ interest = around $5,000

Fixed Amount

With a fixed prepayment penalty, you pay a set amount determined by the lender, such as $3,000. This method of determining prepayment penalties is simple and does not require any calculations.

Sliding Scale Based On Mortgage Length

Let’s assume the prepayment penalty is 2% of the remaining balance in year one and 1% of the remaining balance in year two.

If your remaining balance is around $197,000 near the end of year 1 (assuming a standard payoff schedule), according to the sliding scale, you’ll pay 2% of the remaining balance, totaling $3,940.

If you pay off the mortgage near the end of year 2, you’ll have a remaining balance of around $194,000. Paying 1% of the remaining balance would cost you $1,940.

Interpreting Your Mortgage Contract And Prepayment Clause

As with any financial contract, you should read the fine print. In this case, you’re looking for a prepayment penalty clause in your mortgage contract so you understand how the fee is triggered and the consequences of incurring the fee.

Check For A Loan Prepayment Clause

Go straight to the source for an answer. Ask the lender if they charge a fee for paying off a mortgage early. The law requires lenders to disclose key loan details, including prepayment penalties, monthly payment amounts and other fees.

You should read the “fine print,” which you’ll find in the Loan Estimate or the paperwork you’ll sign at closing. The prepayment penalty and other mortgage loan terms should be displayed prominently in addendums and disclosure documents.

If your lender charges a prepayment penalty, ask them to show where you can find the details in the paperwork. If you already have a mortgage loan, you should find information about the prepayment penalty on your monthly billing statement

Lenders aren’t allowed to add a prepayment penalty clause to certain loans, including:

• Federal Housing Administration (FHA) loans
• Department of Veterans Affairs (VA) loans
• U.S. Department of Agriculture (USDA) loans
• Federal and private student loans

Learn What Will And Won’t Trigger The Prepayment Fee

As we mentioned earlier, making a few extra payments won’t cause the prepayment penalty fee to kick in. But you should be aware of when you can trigger the fee.

Penalties usually cover the first few years of a loan because those are the riskiest years for the lender. If you refinance early into your loan term, you’ll trigger the prepayment penalty. The fee amount will differ based on the penalty fee model in your mortgage contract. See the above models for an example of what that might look like.

Read through your Loan Estimate and contract to know what type of prepayment penalty your home loan has so you know what will happen if you decide to refinance or sell. If you’re unsure, ask your mortgage lender about the prepayment penalty before signing the paperwork. Ask the lender to explain the math as it applies to your specific prepayment penalty, loan amount, amortization and interest rate.