While it sounds odd, a prepayment penalty is a charge you must pay if you pay your mortgage off early. The concept used to be commonplace in the mortgage industry, but today very few lenders still use it. Just in case you come across a lender that requires this type of penalty, you should know what it is to help you decide if you want the loan.
Where do you Find the Prepayment Penalty?
The best way to find out if you have a prepayment penalty is to ask the lender. Do this before you sign the loan documents in case you don’t want the loan any longer. You should also peruse your loan documents carefully. Lenders should disclose the prepayment penalty when they provide you with the Loan Estimate within three business days after applying for the loan. When in doubt, always ask. You don’t want to assume that there isn’t a prepayment penalty; that could be a costly mistake.
Why is There a Prepayment Penalty?
Some lenders use prepayment penalties to help ensure that they make a certain amount of money on your loan. For example, if you take out a 30-year loan, the lender is counting on making interest for those 30 years. If you pay the loan off in say 3 years, the lender will not make nearly what they thought they would when investing in you.
Typically, prepayment penalties are only for the first few years of the mortgage. For example, you may see a prepayment penalty if you pay the loan off in 5 years or less. After that point, lenders don’t charge the penalty because many people sell their homes and pay off their loans after just 5 years. Charging you to pay the loan off early before the 5th year, though, encourages you to keep the loan or pay the penalty.
How Much is the Prepayment Penalty?
Every lender charges a different amount for their penalty. It’s on a loan-by-loan basis. Typically, it’s referenced as a percentage of your loan amount. For example, if you have a $200,000 loan with a 3-year prepayment penalty at 3%, you would have to pay 3% off the current outstanding principal if you pay the loan off before 3 years.
Let’s just assume your principal balance is $198,000. You would then pay a fee of $5,940 to pay the loan off early. This may not make much sense, especially since you’ll probably owe more than you make on the sale of your home this early in the game.
Know the Details
Not every prepayment penalty means that you are penalized no matter how you pay off the loan. Some lenders grant exceptions for borrowers that sell their home, but not those that refinance. Lenders try to prevent you from refinancing by slapping on the prepayment penalty. It’s a way for the lender to keep your business by not allowing you to refinance without a charge.
Ask about the fine print of the penalty even if you plan to keep the loan, though. Some lenders do allow you to make extra payments towards the principal, up to a certain point. The lender calculates how much they want to make on your loan and then maximize your prepayment penalty accordingly.
The prepayment penalty is few and far between today, but it’s still a question worth asking. In some states, the prepayment penalty is illegal, so you won’t have to worry about it. But, in many states, it’s perfectly fine and many lenders still stick to it to make sure that they make enough money on your loan.