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Prepayment Penalties: What They Are And How To Avoid Them

5-Minute Read
Published on October 19, 2020

Everyone wants a lower rate when they get a mortgage, but not one with hidden fees attached. One common hidden fee is referred to as a mortgage prepayment penalty. But what exactly is a prepayment penalty? How can you avoid one?

Fear not: This post holds the answers to these questions, so let’s get into it.

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 early. It’s typically equal to a certain percentage of the overall unpaid principal balance at the time of the payoff.

There are several disadvantages to this type of fee. One of the ways anyone who gets a mortgage avoids paying a lot of interest on their loan is by making extra payments toward the principal over several years in order to pay off their mortgage early. In theory, this works because the lower your unpaid balance, the less overall interest you pay and the sooner you pay off the mortgage.

However, lenders and other mortgage investors make less money if you pay less interest. To get around this, they may give you a rate that looks extremely attractive and lower than others around, but it could come with a prepayment penalty for at least several years into the loan. This discourages you from paying off the loan early, lest you get hit with what could amount to tens of thousands of dollars in fees.

It’s important to note that because refinancing involves paying off your current loan, prepayment penalties discourage doing that as well. This could mean not being able to take advantage of lower rates if they drop or not being able to use your home equity in order to accomplish your goals, such as paying off credit cards, doing home improvements or boosting a college fund.

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How Are Prepayment Penalty Costs Determined?

There are a number of factors that can go into a lender’s determination of how much their prepayment penalty will cost. Some lenders decide on a small percentage of the loan’s remaining balance, while others use the cost of interest on the loan for a set number of months as a reference point for the penalty fee. It can also depend in part on how quickly the borrower pays off their mortgage. If the loan gets paid off in the first year, for example, the prepayment penalty may be higher than if the loan were to be paid off in 2 years.

How Can I Avoid A Prepayment Penalty?

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. It’s our policy, and it’s the right thing to do for our clients.

Tips For Navigating Prepayment Penalty Clauses

If you’re shopping for a mortgage and you’re concerned about a prepayment clause, here are the things you need to know:

  • Make sure you know which laws the lender is governed by. For banks not under federal jurisdiction, 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 time frame has passed. With hard prepayment penalties, the borrower can be penalized if they refinance their property or sell their home during the set time frame.

  • 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 actually saves you any money after the penalty is applied.

Get Started: Find The Right Mortgage For You

Although paying off your mortgage quickly and owning your property outright can be a desirable goal for many homeowners, it’s important to be aware of the unexpected consequences that might accompany such a financial endeavor. Before deciding on a more aggressive mortgage payment plan, make sure you understand whether you will be subjected to a prepayment penalty in the process and if you’ll ultimately be saving more money in the long run.

Are you ready to start shopping for a mortgage? Read more about how to shop for a mortgage to make sure you’re heading in the right direction! Still have questions? Talk to a Home Loan Expert to get your questions answered and start on your home loan today.

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Miranda Crace

The Quicken Loans blog is here to bring you all you need to know about buying, selling and making the most of your home. Whether you’re thinking about becoming a homeowner, selling your current home or looking to keep your place in tip-top shape, our writers and freelancers bring their experience and expertise to meet you right where you are.