What’s a Prepayment Penalty?
Buying a home is exciting, but the mortgage industry can be confusing and hard to navigate. There may be some vocabulary words and terms that you’ve never heard before — “prepayment penalty” is one of them. It may sound a little intimidating, but it doesn’t have to be scary. We’ll break down what a prepayment penalty is and how it may affect your mortgage loan.
First, let’s review a few mortgage loan basics that may help us understand prepayment penalties better.
Your mortgage loan is broken down into monthly payments, which are made up of four things — [principal, interest, taxes, and insurance PITI. - As you make monthly mortgage payments, a portion of your payment goes toward your loan’s principal balance, which is the amount you borrowed and now owe back to your lender. For the first few years of payments, an even bigger chunk of your payment will go towards paying down your interest, which is what your lender charges you for borrowing money from them.
You will make your mortgage payments on an amortization schedule , which will set out the amount you owe each month, breaks down each payment for principle and interest, and includes the date that each payment is due. It will also show you your balances throughout the life of your mortgage loan. You should receive your amortization schedule from your mortgage lender.
What is a prepayment penalty?
A prepayment penalty is a fee a borrower might be subject to pay if they make large payments on their mortgage loan ahead of schedule. Not all mortgages include a prepayment penalty, but if they do, the amount of the penalty and all terms will be included in the mortgage contract that is agreed upon between you, the borrower, and your mortgage lender. Many mortgage lenders will allow you to pay up to 20% of your loan balance each year.
It seems unlikely that you would be able to pay off 20% of your loan balance in a year, right? Well, not necessarily. There are certain instances where this could happen. For example, if you refinance your loan, you pay off your first loan completely and replace it with a brand new one. When you do this, you will pay off more than 20% of your balance.
The same is true when you sell your home — you’d pay off the rest of your loan, which would be more than 20% of your principal balance. What if you get a big promotion at work or inherit a large amount of money? It’s possible that making a large lump sum payment on your mortgage loan could exceed the 20% prepayment cap in one year, too.
While they’re not required for all loans, prepayment penalties are sometimes included in loan agreements because of prepayment risk, which is the risk associated with the unscheduled prepayment of your loan that your lender assumes when you borrow from them.
Prepayment penalties protect mortgage lenders, who rely on the interest a borrower pays as a return on their investment.
Lenders don’t just let you borrow money with nothing in return — they collect interest. When you pay off your loan ahead of schedule, your lender doesn’t collect as much interest, which is how they make money.
Soft vs. hard prepayment penalty
There are two types of prepayment penalties: soft and hard. A soft prepayment penalty lets you sell your home without a prepayment penalty. However, if you choose to refinance your loan, you are subject to pay a prepayment penalty.
If you have a hard prepayment penalty, you could be responsible for paying the prepayment penalty, if you sell or if you refinance.
How much do prepayment penalties cost?
Prepayment penalty costs vary depending on your lender and loan type. For example, let’s say the agreed upon prepayment penalty cost is 2% of your loan balance at the time of repayment. A year into your loan, you decide to sell your home and your loan balance is $200,000. Your prepayment penalty fee would be $4,000.
If there are any prepayment penalties on your loan, your lender should discuss your prepayment penalty options with you and any prepayment penalties should be disclosed on your closing documents.
Is a prepayment penalty right for me?
If your loan program includes a prepayment penalty, your lender may offer you options for determining what the fee is. They should always offer another loan option that does not include a prepayment penalty. But why would you choose to have a prepayment penalty when it’s not required?
A prepayment penalty is not necessarily a bad thing.
Let’s say you agree to have prepayment penalties on your loan for a timeframe of 3 years. To your lender, this is your agreement that you’ll keep your loan for at least 3 years. If you’re not planning to refinance, sell, or pay off a large amount of your loan, having a prepayment penalty fee may not affect you at all.
You should also think about what you want to do with the property. How long do you plan to own your property? Does your job require that you relocate every 5 years or will you be in the area for a while? Are you buying the home as your primary residence or an investment property? Remember that a prepayment penalty applies through a pre-arranged timeframe, so your longterm plans for the property are important.
When you’re getting a mortgage loan, make sure you understand what prepayment penalties are and how they might affect your loan. Consult with an experienced mortgage lender, who should be able to walk you through everything and answer any questions you may have. It’s important to know whether you have a prepayment penalty or not and the conditions of your prepayment penalty before you sign any paperwork for your new home.