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Prepayment Penalties: What You Need To Know

5-Minute Read
Published on October 19, 2020
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When it comes to your mortgage, the last thing you want to do is pay more than you must. Directly attacking the principal and minimizing what you owe in interest is always beneficial. However, some lenders have penalties for paying off your principal too quickly.

By understanding prepayment penalty clauses, you can determine how they affect you and how to avoid them if necessary. 

What Is A Prepayment Penalty?

A mortgage prepayment penalty, also called an early payoff penalty, is the fee that’s charged if you pay off your principal balance before your loan term is up. It’s typically equal to a certain percentage of the overall unpaid principal balance at the time of the payoff.

Your lender may charge a prepayment penalty according to the terms of your mortgage. These can penalize the sale or refinancing of your property if it occurs in the first 2 – 5 years of the loan.

Look at your mortgage documents to verify if you have a prepayment penalty and see the details. Some mortgages, such as those through Rocket Mortgage®, don’t contain a prepayment penalty clause.

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Example Of A Prepayment Penalty

Let’s look at an example with a loan term of $250,000 and an interest rate of 5%.

An interest-based mortgage prepayment penalty is charged if the loan is paid off within the first 3 years. With 6 months of interest charged, your lender would calculate $250,000 x .05 = 12,500/12 months = $1,041.66 x 6 months = a fee of $6,250.

An adjusted fee based on the years remaining on the loan would be $5,000 (2% of $250,000) in year one, $3,750 (1.5% of $250,000) in year two, and so on until the rate is zero.

The prepayment penalty for this mortgage depends on how far the borrower is into the loan. Say the borrower is 1 year into the loan and has an outstanding balance of $235,000, and the prepayment penalty rate is set at 2% of the mortgage balance. The lender charges a $4,700 fee.

Why would a borrower incur the prepayment penalty in any of these scenarios? Let’s take the adjusted fee penalty as an example. You’re 3 years into a 30-year mortgage with a remaining balance of $225,000, and you negotiate better terms with a different lender.

You can refinance your loan to a 20-year mortgage with a 3.5% interest rate, saving you well over $100,000 in interest over the course of the loan. If you can afford the prepayment penalty and closing costs upfront, the refinance is well worth it.

Why Do Lenders Charge A Mortgage Prepayment Penalty?

Lenders primarily make their money through charging interest, and an early payoff of a mortgage means losing out on tens of thousands of dollars (if not more) of interest over the years. The beginning of the loan term proposes more financial danger to lenders because they haven’t had the chance to receive enough payments for the loan to be profitable.

An early sale or refinance of a house is a loss of opportunity for the lender. Since the lender recently sunk resources into providing the mortgage, they’re looking for a return on their investment for years to come, not the loan balance they just lent.

During the closing process, lenders disclose crucial information to the borrower, including the prepayment penalty. So, if you are currently shopping for a mortgage, note the different rates and fees among lenders to pick what suits you best.

What Types Of Loans Have A Prepayment Penalty Clause?

It’s illegal for lenders to include prepayment penalty clauses in U.S. Department of Agriculture (USDA) and Federal Housing Administration (FHA) loans.

If you’re a borrower with one of the following loans or are looking to acquire one such loan, do your due diligence and find out from your lender if your loan has a prepayment penalty clause. Conventional loans, Small Business Administration (SBA) loans, investment property loans, and others can all have prepayment penalty clauses.

Tips For Navigating Prepayment Penalty Clauses

If you’re shopping for a mortgage and you’re concerned about a prepayment clause, here’s what you need to keep in mind:

  • Know which laws the lender is governed by. For banks not under federal authority, state laws may prevent lenders from inserting prepayment clauses. By familiarizing yourself with the policies of the lender, you can also find banks that don’t charge such penalties.
  • If you have a loan with a prepayment penalty, make sure to read the contract. Know the exact terms of any penalty and if it goes away after a number of years.
  • If there is a prepayment penalty, determine whether it’s considered a soft or a hard penalty. With soft prepayment penalties, the borrower can sell their home without consequence, but they will be subjected to the fee if they choose to refinance their property before the established period has passed. With hard prepayment penalties, the borrower can be penalized if they refinance their property or sell their home during the set period.
  • If there is a prepayment penalty, don’t pay it off or attempt to refinance without first doing the math and seeing if doing so saves you any money after the penalty is applied.

Prepayment Penalty Costs

Prepayment fees vary by lender. As a borrower, you should learn about the terms of your mortgage, including the prepayment costs. Since the law requires your lender to provide your mortgage terms before closing day, familiarize yourself with the ins and outs.

You can also ask your lender which documents contain verbiage regarding the prepayment penalty if there is one. Usually the prepayment penalty will come in one of the following forms:

  • A certain amount of interest. For example, your lender may charge you 6 – 12 months’ worth of interest as a penalty for paying off your mortgage early.
  • An adjusted fee based on the years remaining on the loan. In most cases, the rate starts at 2% of the original loan, then decreases gradually (likely half a percentage point) for each following year.
  • A percentage of the remaining loan balance.
  • A predetermined flat fee, which is rarer than the other types of charges outlined.

Note that mortgage prepayment penalty stipulations are lenient up to a point. The standard mortgage lender will allow you to pay up to 20% of your mortgage loan each year with no penalty.

How To Avoid A Penalty For Paying Off Your Mortgage Early

Now that you know what a prepayment penalty is, how can you avoid it? The simplest way to handle it is to find a lender who doesn’t charge a penalty. When considering lenders, ask them about their policy regarding prepayment penalties. If they have one, does it last for a certain number of years or the entire term of the loan? What percentage of the loan does the penalty amount to?

It’s worth noting that certain states don’t allow lenders to charge prepayment penalties. However, even in these states, banks may be regulated by federal instead of state law, so be sure to always ask about the policies and do your research.

Rocket Mortgage doesn’t charge prepayment penalties on any of its mortgages. We believe it’s the right thing to do for our clients.

The Bottom Line

While a prepayment penalty may limit your options as a homeowner, it’s crucial to understand the terms of your mortgage. If the sale or refinance of your home is advantageous, eating the prepayment penalty cost can make sense if your calculations show you coming out ahead eventually.

If your prepayment penalty clause expires soon, you can wait out the remaining time before taking action to avoid the fee altogether. Though some states prevent lenders from charging prepayment fees, it always pays to do your homework in case your mortgage terms include one.

To become an even more savvy home buyer, read more about other mortgage topics and terms.

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Ashley Kilroy

Ashley Kilroy is an experienced financial writer. In addition to being a contributing writer at Rocket Homes, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.