What Is a Prepayment Penalty

The decision to take out a mortgage is one of the biggest financial decisions we make in our lives. For most people, a mortgage is the largest loan we will ever use, and taking on that loan can come with significant risk — not just for us, but for the lender, too.

When a mortgage lender agrees to loan you money so that you can buy a house, the lender expects to make a profit from the loan’s interest over the years of the mortgage. There are risks involved for the lender, though.

For example, if you pay off your mortgage early, the lender loses much of the profit they expected to make over the life of the loan. Lenders use prepayment penalties as a way to recoup some of the lost profit from the loan’s interest. But what are these fees exactly and how do they work?

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    What are prepayment penalties? 

    A prepayment penalty is a clause in a mortgage contact. The clause outlines a fee the borrower must pay to the lender if too much of the loan is paid off earlier than expected.

    It might seem strange to get penalized for paying off your loan early, but mortgage lenders depend on the profit made from the loan interest. To prevent the loss of revenue, some lenders use prepayment penalties as a way to keep the borrower from paying off the loan early. Lenders might also use prepayment penalties as a way to hand out lower interest rates to borrowers while offsetting the risk.

    Not all mortgages come with a prepayment penalty, and not all prepayment penalties work the same way. If you do have a prepayment penalty in your mortgage contract, it will only kick in if you pay off a certain, specified amount in a specific timeframe, such as paying off more than 20% of your mortgage within a year.

    How to avoid prepayment penalties

    To avoid a mortgage prepayment penalty, it’s important to understand exactly what will trigger the penalty. It’s the law for any prepayment penalty to be disclosed to you before you agree to the mortgage. So, if there’s anything you don’t understand about the contract, and the prepayment penalty in particular, make sure to ask follow up questions.

    If you just pay your mortgage down using the standard monthly schedule, then you don’t have to worry about a penalty. However, if you want to pay off your mortgage early without drawing a penalty, you’ll have to pay close attention to the fine print in your mortgage contract.

    You can usually pay more than the minimum amount without a penalty. How much more you can pay will be stated in your contract. Be aware, though, that some prepayment penalties can change over the life of the loan. Check the mortgage details to see if the penalty drops off after a certain period of time or adjusts at any point so you know exactly what you’re getting into.

    Another way to avoid prepayment penalties is to find a mortgage loan that doesn’t have one. Not all mortgages come with prepayment penalties, so you should shop around and see what’s available from different lenders before making a final decision.

    What are typical prepayment costs?

    The cost of prepayment penalties typically work in one of three ways. The penalty can be a fixed amount, a percentage of the mortgage balance or a sliding-scale amount based on a length of time in the mortgage life cycle.

    What are they?

    Let’s run through a quick example for each method of calculating a prepayment cost. This will be based on a mortgage in the amount of $250,000.

    • If the penalty is fixed, you’ll pay a flat fee — usually a few thousand dollars or so.
    • If the penalty is a percentage of the mortgage, say 2%, then the penalty would be $5,000 on a $250,000 loan.
    • If the penalty is a sliding scale, say $6,000 for year one or $3,000 for year two, then the penalty would be a fixed amount based on which year the mortgage is paid off.

    How do I know if I have a prepayment clause on my mortgage?

    By law, lenders have to tell borrowers if a mortgage loan comes with a prepayment penalty. You won’t be in a situation where you’re taking out a mortgage and wondering if it comes with a penalty or not. Prepayment clauses will be included with the other terms of your mortgage in the disclosure documents.

    What will cause me to pay the fee?

    If you’re worried about prepayment, mortgage contracts will state the exact situation that will trigger a fee from a prepayment penalty. You should know the prepayment clause in your mortgage contract inside and out. It will guide you away from any situation that would trigger a fee.

    Prepayment clauses 

    A prepayment clause will be stated in the disclosure documents included with a mortgage contract. The prepayment clause will state exactly how much you can overpay without incurring a penalty. It will also state what the charge will be and how it’s calculated.

    If there’s anything in the prepayment clause that you don’t understand, we encourage you to speak with the mortgage lender and ask as many questions as you need to in order to have a firm understanding of how much you can pay without getting charged.

    It’s also important to keep in mind that some mortgages come without a prepayment clause, so you don’t have to take out a loan that penalizes you for paying off the loan early. You have other options.

    How to avoid paying more for prepayment

    The best way to avoid prepayment penalties is to understand how your mortgage works. If you want to pay off your mortgage early, there’s generally a certain amount you can overpay without getting hit with a fee.

    It’s also a good idea to read your contract to see if the prepayment fee goes away after a certain amount of time. You could save thousands of dollars in penalties by simply waiting to pay off your mortgage until the penalty drops off.

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    Julian Dossett

    Contributing Writer

    Julian writes about what’s coming next, covering stories from artificial intelligence to cryptocurrency. He lives with his wife in Albuquerque, New Mexico. Whenever he has a day off, Julian can be found at Isotopes Stadium watching the ballgame.