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Crack open a finance book, scroll through Instagram, listen to a money podcast or watch a financial pundit on TV. Almost all of them will share a common rule of personal finance management: Pay off your debts sooner rather than later.
While this rule of thumb has its place in everyone’s money management action plan, there are mortgage loans that might make it harder to follow the “sooner rather than later” part of the rule.
Some mortgage loans come with prepayment penalties. If you decide to pay off one of these mortgages early, you risk paying a tidy sum in fees.
Regularly paying your monthly mortgage payments is always a good thing. But prepaying could hurt your pockets if your loan comes with a prepayment penalty clause.
Fortunately, there are a few scenarios where you can use your hard-earned dollars to prepay your mortgage without having to deal with the fee. Knowing more about prepayment penalties and how they work can help you stay on the right track with your mortgage.
What Is a Prepayment Penalty and How Does It Work?
A prepayment penalty is a fee some mortgage lenders charge if a borrower pays all or part of their loan off early. These fees can differ by state and local laws and regulations.
Mortgage prepayment penalties usually only apply during the first 3 – 5 years of a loan.
Some lenders charge a fee that is a percentage of the mortgage’s outstanding balance. The charge typically starts at 2% for the first year and goes down every year until it reaches 0%.
But not all lenders choose the percentage fee method. Some opt for a fixed fee or will charge interest for a specified number of months.
In general, the goal of the fee is to discourage borrowers from paying off their loans early. Lenders “bank” on the interest from the loan. The fee encourages borrowers to pay on schedule and allows lenders to collect full interest on the money they lend you.
Mortgage lenders have to disclose prepayment penalty details when you close a new mortgage. The prepayment clause will include details about the fee, including how much it is, when it gets triggered and so on.
Believe it or not, when it comes to prepayment penalties, we have good news and more good news. First, not all lenders include prepayment penalties in their mortgage contracts.
And second, whether your loan includes a prepayment penalty clause or not, borrowers can usually pay a little extra on their mortgage without triggering the fee. Most lenders allow borrowers to make extra payments each year as long as they don’t pay off more than 20% of the loan’s balance.
Prepayment fees typically kick in either when you’ve gone over the 20% threshold or you’ve paid off your entire mortgage before the end of the loan’s term.
The prepayment penalty can also include a refinance penalty if you refinance within the first few years of taking out your mortgage.
Why Do Lenders Charge Prepayment Penalties?
A lender takes on the majority of the risk for the first few years of a mortgage loan. That’s because, at the start of loan repayment, the borrower has paid back very little money toward their principal compared to how much they borrowed from the lender.
To offset that risk, in the first few years, most of your mortgage payment goes toward paying interest, not your principal balance. During these first few years (usually 3 – 5 years), the lender can make a considerable gain on interest.
Prepayment penalties are there to help ensure that lenders will be able to collect interest on the loan during these first few profitable years. The fee also helps lenders recover some of their losses in interest.
Example of a Prepayment Penalty
Let’s say you have a $375,000 mortgage that comes with a 3.99% interest rate for 30 years, and the mortgage contract you signed has a prepayment clause for the first 5 years of the loan.
After 2 years of payments, the balance on your mortgage is $361,500.44. You come into some unexpected money and decide that you want to make an additional payment of $100,000.
If you enjoy a 20% prepayment allowance every year and haven’t made use of it, check to see if it rolls over to the next year. If it doesn’t, you only have a 20% prepayment allowance to work with. If you go ahead and make the extra $100,000 payment, the penalty fee (let’s say it’s 1.5%) will be triggered, and you’ll have to pay an extra $5,422.51.
Before you decide whether the fee is worth it, look at your amortization schedule. Figure out if making the extra payment will save you more than $5,423 in interest. If the answer is “yes,” this would likely be a cost-effective decision.
How Much Are Prepayment Penalties?
Prepayment penalty costs vary and are determined by some key factors in your mortgage, including:
- Remaining balance
- Length of loan
- Interest rate
Prepayment penalties are often established on a sliding scale. As you get further into your mortgage, the fee lowers and eventually disappears. Here’s an example of a possible prepayment penalty schedule with a sliding scale:
|Year of Mortgage||Prepayment Penalty (as Percentage of Outstanding Balance)|
Let’s go back to our earlier example of the $375,000 mortgage with a 3.99% interest rate for 30 years.
Let’s say that in year 4 of your mortgage, you visit another lender and realize that you can refinance to a 3.20% interest rate.
You can’t pass up the rate, so you decide to refinance. That means you’ll have to pay off your outstanding balance of $346,881.41 with your current lender using the funds from your refinance.
According to the sliding scale, you’ll be charged a prepayment penalty of 0.75%. That means you’ll have to pay a $2,601.61 prepayment penalty fee to refinance. Check out your amortization schedule to see if this fee will be worth it in the long run.
Need Tips for Navigating Prepayment Penalty Clauses?
It can be challenging to understand your loan’s specific prepayment penalties, but the following tips can help:
1. Find out if your loan has prepayment penalties
You can always find out if you have prepayment penalties, thanks to the 2010 Dodd-Frank Act.
The Act issued wide-ranging financial reforms on the heels of the 2008 financial crisis, including regulations around what lenders must do when dispensing a mortgage.
One of those regulations is that lenders who include prepayment penalty clauses in their mortgage contracts must disclose those details at the closing of the new mortgage and include those details in the contract.
BTW, prepayment charges are illegal for certain types of mortgages, including:
- Federal Housing and Administration (FHA) loans
- Department of Veterans Affairs (VA) loans
- U.S. Department of Agriculture (USDA) loans
2. Know hard penalties from soft penalties
There are two types of prepayment penalties: soft and hard.
A soft prepayment penalty only applies to refinancing. If you sell your home or pay off a large portion of your mortgage in the first few years, you won’t trigger the prepayment penalty.
A hard prepayment penalty applies to selling your home, refinancing or paying off a large portion of your mortgage early.
Check your prepayment clause and see if you’ve got a soft or hard penalty. The difference between the two can significantly impact your decision to move forward with selling your home, paying off your mortgage loan early or refinancing.
How Do You Avoid Loan Prepayment Penalties?
To avoid prepayment penalties, it’s crucial that you read your loan’s prepayment clause and understand which scenarios trigger prepayment fees.
But there are a few ways a borrower can avoid a prepayment penalty fee altogether:
- Try negotiating with the lender for a possible lower penalty fee or ask for a nonpenalty loan. Because of the 2010 Dodd-Frank Act, all lenders are required to offer a nonpenalty loan option. Just keep in mind that the nonpenalty option might come with a higher interest rate.
- Consider refinancing your current loan to one that doesn’t have the fee. You can often refinance at a lower interest rate. The savings from that may cover any prepayment penalty you would have to pay for refinancing.
- Don’t pass the 20% threshold. Most lenders allow you to pay up to 20% of your outstanding balance every year without triggering a prepayment fee. If you stick to this limit, you could have your entire mortgage paid off in less than 5 years.
- Consider selecting a lender that doesn’t charge prepayment penalties during the early stages of the home buying journey, especially if you anticipate paying off your mortgage within 5 years or so.
Should You Take a Loan With a Prepayment Fee?
A prepayment fee on a mortgage loan doesn’t have to be a deal breaker. What matters is knowing what you’re going to do with your home in the near future. If there’s a strong chance that you might refinance or sell during the first 2 – 3 years of the mortgage, then there’s a strong chance that you’ll set off the prepayment penalty.
To Prepay or Not To Prepay
Prepayment isn’t an option for everyone, but it can help shrink your debt faster if you can afford it. Because prepayment penalty fees are normally large fees, it’s important to keep them in mind as you consider debt-paydown strategies. Understanding the rules around prepayment can help you make an informed choice.
The decision to prepay must be made on a case-by-case basis. In some cases, it might be better to wait out your prepayment penalty term. In other cases, you’ll need to do a cost-benefit analysis to figure out whether the amount you save on interest will outweigh the cost of the prepayment fee.
Commodity Futures Trading Commission. “Dodd-Frank Wall Street Reform and Consumer Protection Act.” Retrieved November 2021 from https://www.cftc.gov/sites/default/files/idc/groups/public/@swaps/documents/file/hr4173_enrolledbill.pdf