What Is a Prepayment Penalty?
Let me explain what a prepayment penalty is. It's a clause in your mortgage contract that says you'll face a penalty if you pay down or pay off your mortgage significantly before the term ends, usually in the first three years after you commit to the loan. This penalty might be a percentage of what's left on your mortgage balance, or it could equal a few months' worth of interest. I want you to know that these penalties exist to shield the lender from losing out on interest income that they'd otherwise collect over time.
Key Takeaways
Here's what you need to remember: a prepayment penalty clause means you'll get hit with a fee if you pay down or off your mortgage big time, often within the first five years. These penalties are there to protect lenders from missing out on interest. And remember, mortgage lenders have to tell you about any prepayment penalties when you're closing on a new mortgage.
How a Prepayment Penalty Works
Prepayment penalties get written into mortgage contracts by lenders to cover the risk of you paying early, especially in tough economic times or when refinancing a subprime mortgage makes sense for you. These aren't just for when you pay off the whole loan; some kick in if you make a large payment that knocks down a big chunk of the balance.
Including a prepayment penalty helps guard against you refinancing or selling your home too soon after closing, say within the first three years, when the lender sees you as a risk. Sometimes, they're added to make up for offering a lower interest rate than usual.
Lenders must disclose these penalties at closing, and they can't impose them without your consent or knowledge. But you should ask about them early on, well before closing, if the lender hasn't mentioned anything. Making small extra principal payments over the loan's life usually won't trigger penalties, but check with your lender to be sure.
Types of Prepayment Penalties
There are different types you should know about. A 'hard' prepayment penalty applies to both selling your home and refinancing. A 'soft' one only hits you for refinancing.
Limitations of Prepayment Penalties
Not all loans have these penalties, and there are rules. They're not legal on single-family FHA loans. For other home loans, lenders can only apply them in the first three years, with caps on how big the penalty can be. Plus, they have to offer you a loan option without a prepayment penalty. These limits come from the Consumer Financial Protection Bureau (CFPB) rules after the 2010 Dodd-Frank Act, for loans issued after January 10, 2014.
VA mortgage loans for military personnel and student loans don't allow prepayment penalties at all.
Special Considerations
Prepayment penalties differ between lenders, so you need to ask for and understand the prepayment disclosure document before closing. They might be a fixed amount, a percentage of the remaining balance, or based on a sliding scale depending on how long you've had the mortgage.
Some lenders charge if you refinance or sell within the first two to three years, while others go up to five years.
Example of a Prepayment Penalty
Consider this example: if you have a two-year-old mortgage with $250,000 left and decide to refinance, a 4% prepayment penalty means you'd pay $10,000 to your original lender for paying it off early. You should always check the details of your lender's penalties, as they can add a lot to the cost of refinancing or selling your home.
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