Most people would consider it a good thing to pay off a loan early. But what if you were penalized for doing just this? The truth is, some home loans may be subject to a mortgage prepayment penalty in which you’ll actually owe your lender money for paying off your loan. Before you sign any loan agreement, make sure you’re aware of any prepayment clause that might be included in your contract.
How To Avoid a Prepayment Penalty
- Shop for Loans that Don’t Have a Prepayment Penalty
- Avoid Frequent Refinancing
- Stay in the Home Longer at Least 3-5 Years
- Wait to Pay Off Loan Until Fee Have Phased Out
- Negotiate with Your Lender
However, just because your loan contract contains a prepayment penalty doesn’t mean it’s not the right mortgage loan for you. For certain borrowers, a loan with a prepayment penalty clause may be their best option. As long as they have a clear plan for their real estate investment and they stick to it, it doesn't have to negatively impact them. For others who may be unsure of their financial goals or are seeking more flexibility with their home purchase, it’s wise to avoid home loans that include prepayment penalties.
What Is a Prepayment Penalty?
When a mortgage lender agrees to extend a home loan to a borrower, they’re assuming a calculated level of risk in exchange for receiving a regular monthly payment that includes interest. For however long the loan term is (be it 10, 20, or 30 years), the lender expects to earn a certain amount in interest income to make it worth the risk. The longer the loan lasts, the more the lender makes. If a borrower pays off their loan balance earlier than expected, the lender might impose a prepayment fee to recoup their losses.
This risk is highest in the earliest years of the loan. The terms of these penalties will vary by lender and your specific loan and will often have provisions for how long the loan has been held, whether you’re selling or refinancing your home, or whether you’re making a large, lump sum payment toward your principal.
Essentially, prepayment penalties can be added to the terms of a residential mortgage loan by your lender as a way of protecting their investment. As a way to entice the buyer, lenders may offer slightly lower interest rates on the loan document if it has prepayment protection.
Prepayment penalties are often included on non-conforming loans or non-qualified loans – for example, if you don’t have two years of income in the same field or your debt-to-income (DTI) ratio exceeds the lender’s cap. These added fees can also apply to certain other types of loans for commercial real estate, like a commercial mortgage-backed securities (CMBS) loan, personal loans from the Small Business Association (such as an SBA 504 loan), or an auto loan.
How Much Is a Prepayment Penalty on a Mortgage?
There are a few different prepayment penalty fee structures that consumers might encounter and each requires the borrower to pay in a slightly different way. By law, your lender must disclose any fees or prepayment penalties upfront. Although the terms of your loan should be made clear to you by your lender, it’s always the responsibility of the borrower to make sure they fully understand the fine print and ask questions if they’re unsure. If you already have a loan in place but aren’t sure if it’s subject to prepayment fees, call your lender and ask.
The most common prepayment penalty fee structures are as follows:
Percentage of Remaining Loan Balance
Under these terms, the lender will charge the borrower a percentage of the remaining loan balance if they pay off their mortgage within a certain amount of time (typically two to three years). For example, if the borrower had $200,000 left on their principal and paid it off early, they may be charged a 2% penalty of $4,000.
Fixed Amount
Although very few lenders use this structure anymore, you may be charged a flat fee (such as $4,000) for paying off your loan too early.
X Number of Months’ Interest
Another way you may see a penalty clause is when the lender charges a predetermined number of months’ interest, usually three to six. So if your loan was $200,000 at a 6% rate you’d pay $12,000 a year in interest. If your prepayment penalty was set at four months, you’d then owe $4,000.
Sliding Scale
The most common type of prepayment penalty is a sliding scale (also called a step-down prepayment penalty) which takes into account the age of the loan. For example, if a borrower paid off their loan in one year, they may have to pay 2% of their remaining principal balance as a fee, but if they paid it off after two years they’d only have to pay 1%. So, if the borrower paid off their $200,000 loan in one year, they’d have to pay $4,000. If they pay it off in two years, the penalty drops to $2,000.
Federal law also regulates these charges. For the first two years, lenders can’t charge more than 2% of the loan balance, and no more than 1% in the third year of the loan.
Soft Prepayment Penalty vs a Hard Prepayment Penalty
You may see prepayment penalty fees structured as either a “soft” prepayment penalty or a “hard” prepayment penalty. A soft penalty is only applied if you refinance your home or pay off a large portion of it in the first couple of years. It’s worth noting that making an extra payment here and there will not trigger a prepayment penalty. Most lenders will allow borrowers to pay up to 20% of their principal balance in a single year, but anything more than this would be subject to penalty.
The soft model is designed so that the borrower is not penalized for selling their home. A hard penalty, on the other hand, is imposed for refinancing a mortgage, paying off a large portion of your balance, or selling the home.
Are Prepayment Penalties Legal?
In most cases, charging a mortgage prepayment penalty is completely legal, but there are some loans where these fees are prohibited by law. Per new legislation passed by the Consumer Financial Protection Bureau in 2014, many conventional residential loans can no longer include this fee. As well, a government-backed mortgage like an FHA loan, USDA loan, or VA loan can have no prepayment penalty included. Before this change in legislation, prepayment penalties were far more common and could often run as high as 3% to 5%.
Federal law also makes it illegal to charge this fee on a student loan or personal loan. However, even within a prepayment penalty mortgage, there are limits on what lenders can and cannot do. Typically, lenders can only impose these penalties within the first three years of a loan, and they also must offer the borrower an alternative mortgage option that has no prepayment penalty.
How To Avoid a Prepayment Penalty
Shop for Loans that Don’t Have a Prepayment Penalty
Per federal mortgage regulations, if a lender shows you a loan package that contains a prepayment clause, they must also show you an option without a prepayment risk. If you are hoping to pay off your mortgage early, you should specifically ask your lender about the repayment terms of the loan and tell them you’re trying to avoid a prepayment penalty.
Meet different types of mortgage lenders when getting quotes because they’ll all be able to offer you slightly different terms and closing costs. Some lenders will specifically advertise that their loans don’t impose prepayment penalties. Regardless of what lender you go with, you should always read over the terms of your loan thoroughly and ensure you understand them.
Avoid Frequent Refinancing
It may be enticing to refinance your mortgage when you see the average interest rate start to drop, especially if your original interest rate was high. But while refinancing may lower your monthly payment, it will also cost you money upfront. Even if you don’t have to contend with a prepayment fee, you’ll still have to pay closing costs and you may have to buy down the points on your loan.
If you do have a prepayment penalty clause in your mortgage, you’ll also be paying a penalty on top of the closing costs. So, if you know you’re going to refinance in the next couple of years, be sure you won't be penalized for paying off your loan early. Additionally, try to wait at least three years between each refi to make sure it’s actually saving you money in the long run.
Stay in the Home Longer at Least 3-5 Years
Because most lenders are prohibited from charging prepayment penalties after three years, most borrowers will be safe selling or refinancing after they’ve been in their home for three to five years. By waiting to pay off your loan, you will have also built up more equity in your home and will have more options in front of you.
Wait to Pay Off Loan Until Fee Have Phased Out
Most prepayment fees will phase out after two or three years, so if you can wait this long to pay off your loan, you could be saving yourself thousands of dollars. If the penalty is unavoidable and you're on a sliding scale model, you can always wait a year to sell and save yourself some money by only paying 1% of your remaining principal rather than 2%.
Negotiate with Your Lender
If you want to sell early and are facing a prepayment penalty, you can always try contacting your lender directly and try to negotiate. Depending on your relationship with your lender they may agree to lower the fee or remove it altogether. Negotiation may also work in the beginning stages of a loan for lowering the penalty before finalizing your contract.
Home Loans with Prepayment Penalties
For the average borrower, you’ll likely want to avoid any loan with a prepayment penalty associated with it simply because it poses too big a risk. No one ever knows quite what life will throw at them and if you have to unexpectedly move your family across the country and sell your house, the last thing you want is a surprise charge from your lender.
Even if you’re sure you’ll stay in your home for the next 20 years, it’s always a good idea to know about these penalties in case you have an unforeseen change in circumstances. That said, some homebuyers or real estate investors may be willing to take on this risk, but should only do so after exploring all their other options and ensuring the amount they stand to gain from selling outweighs the hit they’ll take in prepayment fees.
