Prepayment Penalty: Definition and Avoidance
Prepayment penalties are strange to many homeowners. Why punish early loan repayment?
That’s mortgages: Many of them have prepayment penalties, which limit your flexibility and can drain your wallet for doing the right thing financially. We’ll explain why lenders don’t want you to pay off your mortgage early.
Prepayment penalties are important when choosing a mortgage. They may be hidden in mortgage contracts. Learning about penalties now will help you find the right mortgage lender.
Some lenders charge a fee for early mortgage prepayment. The penalty fee encourages consumers to repay their principal slowly, allowing mortgage lenders to receive interest.
It doesn’t usually kick in when you make extra payments or principal-only installments to pay down your debt faster. Most mortgage lenders let consumers pay 20% of the loan total annually. Instead, a mortgage prepayment penalty occurs when refinancing, selling, or paying off a large loan.
Why Do Mortgage Prepayment Penalties Exist?
Usually, a lender wants their money back quickly. Why mortgage lenders don’t.
Lenders take more risk in the first few years of a loan. Most borrowers haven’t put down much relative to the house’s worth. “Interest” protects lenders from financial loss. If you pay off the loan immediately, they lose all the interest fees they provided to entice you to borrow.
Several lenders use the mortgage penalty to market lower interest rates, knowing they will make up the difference throughout the life of the loan or receive a prepayment penalty if you pay off the mortgage before they have recouped their costs.
Prepayment penalty fees differ. There are some standard penalty cost models:
- Percentage of remaining loan balance: If the loan is paid off within two or three years, they charge a modest percentage, like 2%, of the outstanding amount as a penalty.
- X months’ interest: You pay 6 months’ interest.
- Constant: The lender writes down a fixed amount, like $3,000, for paying off a debt within a year. Mortgages rarely use this.
- Mortgage-length-based sliding scale: The most prevalent model. Example: a sequential 2/1 prepayment penalty over the first 2 years of the loan. The penalty is 2% of the mortgage debt if paid off in year 1. Year 2 penalties are 1% of the main balance.
Math fun? A typical mortgage and interest rate model yields this. Hypothetical $200,000 loan.
If you have 10% equity before paying off the loan, the penalty is $3,600 ($180,000 x 2%).
Interest: X months. The penalty is $5,000 if the loan is paid off in the first two years ($200,000 x.05= $10,000/12 months = 833.33 x 6 months penalty amount = $5,000).
Constant: You would pay $3,000.
Mortgage-length-based sliding scale: For a $200,000 loan, the mortgage penalty is $4,000 in year 1 and $2,000 in year 2.
Mortgage Contract Interpretation
Read the fine print in financial contracts. If your mortgage contract has a prepayment penalty clause, you’ll need to understand the ramifications of triggering it.
Checking for a prepayment clause?
The good news is that lenders must disclose prepayment penalties, monthly fees, and other loan terms by law. As indicated, read the “fine print” in the loan estimate or the documentation you’ll sign at closing, where it will be prominently listed in the addendums and/or disclosure documents with the other mortgage loan terms.
Ask your lender if they impose a prepayment penalty and where to locate the specifics. If you have a loan, your monthly billing statement should list it.
Prepayment penalties can be illegal. Examples:
- FHA loans
- VA loans
- USDA loans
- Personal or student loans (These loans aren’t mortgages, but it’s useful information.)
- Discover The Loan Triggers. Prepayment Fee
- As noted, extra payments will not trigger the prepayment penalty cost. You should be aware of other occasions when it will.
Prepayment fines come in two forms:
If you refinanced or paid off a lot of the loan early on, a light prepay penalty lets you sell your house without a penalty.
If you sold the home or prepaid, a harsh prepay penalty would apply.
As the first few years are the riskiest for the lender, penalties cover them. Refinancing early incurs the prepayment penalty. Mortgage penalty fees vary. View the models above.
If you refinance or sell, check your Loan Estimate and contract for prepayment penalties. Before signing, ask your mortgage lender to explain the math for your prepayment penalty, loan amount, amortization, and interest rate.
Is one more fee unsettling? It should—no one wants to pay extra, even when they think they’re doing something sensible for their finances. Before signing, consider:
Just in case, you should know the penalty fees. If the charges are high, it could make the difference between a prepayment penalty loan and one without.
Find out your mortgage’s prepayment penalty and compare the cost of continuing in your loan past the penalty deadline to paying it off early and activating the penalty. Homebuyers must choose the finest option for their finances.
While anything can happen, these questions can help you assess the possibility, i.e., how anxious you should be about a prepayment penalty:
Selling or refinancing your property soon?
If you’re going to stay in one spot for a while (as far as anyone can tell), the penalty may not apply.
Refinancing is uncommon if you have a low interest rate.
Do you value early payment?
If long-term debt and monthly payments are too stressful, seek mortgage lenders without prepayment penalties in case you get a windfall and want to pay it off. Refinancing your mortgage may also help you consolidate debt. If you do, you’ll lose the mortgage interest deduction, so examine all financial concerns.
If you keep your lender and mortgage with the penalty, you can negotiate a reduced price. Even if you anticipate to stay in your new home for years, it may be worth bargaining to reduce your risk.
Ask your lender to waive it. If they agree—unlikely but worth a try—get it in writing. Asking your lender for a quote without penalty may raise your interest rate.
Finally, look for mortgage lenders without mortgage prepayment penalties to avoid long-term hassles.
Avoid Prepayment Fees
Remember that there are alternatives to accepting a prepayment penalty. You can negotiate, but switching loans or lenders is the easiest way to avoid the cost.
To discover the best loan, compare prepayment penalties from different lenders.
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