Are you considering selling your home, refinancing your mortgage, or making a larger mortgage payment than usual? Any of these actions could result in a prepayment penalty from your mortgage lender, which could cost you thousands of dollars if you’re not careful.
Though they are becoming increasingly rare and limited by law, prepayment penalties do exist and apply primarily to the early years of a mortgage. Here’s how they work:
What is a prepayment penalty?
A prepayment penalty is a fee charged by a lender to discourage a borrower from rolling over a mortgage or closing much earlier than the scheduled term, usually equal to a percentage of the loan principal.
The good news is that most borrowers aren’t subject to prepayment penalties today, but it’s important to check before taking out a mortgage or refinancing, putting your home on the market, or trying to pay off your mortgage early.
Why do lenders charge prepayment penalties?
Mortgage lenders and banks make more money when you pay off your loan over a longer period, such as a 30-year loan, because the interest accrues over the life of the loan. If you pay off your loan early by selling your home, refinancing into a new loan, or making additional payments on the principal, the lender makes less money for you, penalizing you for reducing the number of years of interest payments that the lender would have earned.
“Lenders charge prepayment penalties to incentivize people to keep their loans for longer than a year or two,” says Kate Bulger, vice president of business development at Money Management International, a nonprofit financial counseling agency in Atlanta.
Types of prepayment penalties
There are two types of prepayment penalties: soft and hard. Soft prepayment penalties apply in fewer circumstances than hard prepayment penalties.
Soft Prepayment Penalty
If your loan has a soft prepayment penalty, it will only apply if you decide to refinance your loan. The penalty amount is due at closing, so you’ll need to have cash on hand to make the payment.
In some cases, soft prepayment penalties may apply if you pay off most or all of your mortgage within a calendar year. See below for more details.
Hard Prepayment Penalty
A hard prepayment penalty can be caused by a few different situations. It can happen if:
- Refinance your mortgage
- Selling a House
- Pay off the entire mortgage balance before the end of the term
- Pay a large portion of your mortgage
How much is a “significant portion”? “Making a few extra payments toward your principal or paying a little extra each month usually isn’t enough to trigger a prepayment penalty,” says Bulger. But if the total exceeds 20 percent of your loan balance in a given year, the penalty could be triggered.
If your mortgage has steep prepayment penalties, paying off your mortgage early may not be the best financial decision. Ask your lender how much you’ll pay in penalty fees and how much you’ll save in interest payments. A mortgage repayment calculator can help you determine if and when a prepayment makes sense.
How the prepayment penalty works
If you’re charged a prepayment penalty, you’ll have to pay it in one lump sum to your lender. If you sell your home, it’s taken from the sale proceeds. If you refinance your loan, it’s part of your closing costs. It’s a separate fee if you close your loan early or pay off one-fifth of it in one year.
“When you’re comparing loans, there will always be a penalty listed in the mortgage interest rate quote,” says Anna DeSimone, a New York City-based personal finance expert and author of the guide Housing Finance 2020. “You’ll usually see language like, ‘If your mortgage is terminated within 12 months, you will pay a prepayment penalty fee equal to three months’ interest.'”
St. Petersburg, Fla., attorney Charles Gallagher says the terms and language of the agreed-upon percentage penalty will also be written into the mortgage documents.
Do all mortgages come with a prepayment penalty?
The Dodd-Frank Act established limitations on prepayment penalties that went into effect in 2014. Currently, prepayment penalties are only imposed on conventional loans that are originated and guaranteed by private lenders, and therefore do not apply to FHA, VA, and other government-insured or government-guaranteed loans.
Among conventional loans, the penalties are mostly tied to “non-conforming mortgages, meaning loans that aren’t sold or guaranteed by a government-sponsored enterprise like Fannie Mae or Freddie Mac,” DeSimone said. Penalties could also be assessed on non-qualified (non-QM) mortgages, which are targeted at applicants who don’t fit the traditional borrower profile and therefore have looser standards but higher fees.
How much is the prepayment penalty?
The Dodd-Frank Act also places limitations on the size and timing of prepayment penalties. The fee can only be imposed during the first three years of a loan’s term. The penalty is 2 percent of the principal balance during the first two years of the loan and 1 percent of the loan balance during the third year.
For example, let’s say you buy a home with a nonconforming mortgage and then sell it just a year later. Let’s say the remaining balance is $300,000. At closing, you’ll probably be hit with a prepayment penalty of $6,000, which is the equivalent of 2 percent.
How is the prepayment penalty calculated?
A prepayment penalty can be charged in a variety of ways. It may be calculated as a percentage of the remaining loan amount, usually between 1 and 2 percent. The penalty may equal a certain number of months of interest. Or, some lenders may charge a flat fee.
Details of prepayment penalties will be stated in your loan agreement.
Keep in mind that federal law prohibits prepayment penalties of more than 2 percent of the loan amount, which is the maximum you can pay.
Prepayment Penalty Example
Here’s another scenario for prepayment penalties: Let’s say you bought a home 19 months ago and financed it by borrowing $200,000 with a nonconforming mortgage. Now, interest rates have dropped significantly, so you want to refinance to lower your monthly payments.
“In this case, you’ll be assessed a penalty of $4,000, or 2% of the balance, for refinancing within the first two years of the loan,” Bulger says.
In contrast, imagine you inherited a large unexpected sum of money and decided to use $30,000 of it to pay off your $200,000 mortgage early. “In this scenario, you wouldn’t be assessed a prepayment penalty,” Bulger says. “That’s because the $30,000 accelerated repayment amount is less than the maximum 20 percent that lenders allow in prepayments each year.”
How to identify prepayment penalties in loan agreements
It’s always important to understand what you’re agreeing to before signing any mortgage agreement, especially when it comes to prepayment penalties that may be buried in the fine print.
Where to find information about prepayment penalties
Federal law requires lenders to disclose all information about prepayment penalties. If there is a prepayment penalty, it must be stated in the Loan Estimate or Disclosure Document.
You can also ask your lender if there are any prepayment penalties, and if they say yes, ask them to tell you where in the paperwork they provide the details.
How to Interpret Prepayment Clauses
The prepayment clause in your mortgage agreement tells you how to pay off your loan early. This section of the document explains exactly what you need to do to pay off your mortgage sooner than scheduled. It also outlines if there are any prepayment penalties you may incur, and how much they may be.
Think about a 3-5 year plan ahead. Is it possible to refinance, sell your home, or pay off a lot of your loan in that time? Even if you don’t plan on paying off your mortgage early, understand the costs of doing so. Don’t get locked into a loan that will cost you a lot to pay off.
How to avoid prepayment penalties
If you don’t want to pay a mortgage prepayment penalty, consider these tips to avoid the cost.
- Shopping at the market: Shop around among different lenders and avoid loans that charge fees. According to Experian, Dodd-Frank requires lenders that charge upfront fees to also offer no-fee mortgage options.
- Call your mortgage lender/servicerAsk if a prepayment penalty applies to your current mortgage.
- negotiate: If you have a prepayment penalty on your mortgage, ask to have it removed or negotiate a lower penalty.
- Carefully time your home sale, refinance, or payment acceleration strategy: See if you can wait until the first three years are up, after which you won’t be penalized.
Frequently asked questions about mortgage prepayment penalties
Additional reporting by Emma Woodward
