Failing to understand the prepayment penalties for mortgages could lead to trouble down the road.
In this article, I will dive into all the basics of prepayment penalties, the different types, and help you decide if it’s better for you to be prepaying or refinancing.
IMPORTANT: Dealing with a prepayment penalty is not common! Fannie Mae, Freddie Mac, FHA Loans, VA Loans, USDA Loans, and the state of Illinois do not permit prepayment penalties. NewCastle Home Loans does not offer prepayment penalties.
What is a mortgage prepayment penalty?
A prepayment penalty is an agreement between the borrower and lender that informs how much and when the borrower can pay off the loan. The penalty is based on a percentage of the remaining mortgage balance or a certain number of months’ worth of interest. It's common for lenders to allow borrowers to pay off up to 20% of their loan each year.
In short, a prepayment penalty charges you a fee if you pay off the mortgage early.
What are the types of prepayment penalties?
There are two types of prepayment penalties: "soft payment penalties" and "hard payment penalties."
The “soft payment penalty” does not penalize a borrower regardless of when they sell their home. However, if they choose to refinance, they would be subject to the penalty.
The "hard payment penalty" penalizes the borrower whether they refinance or sell their home. This really limits the borrower if they end up needing to sell their home quickly.
Typically, the prepayment penalty is equal to 80% of six months’ interest. This can vary, but in the example where the borrower can pay 20% each year, they will be penalized on the 80%. The following is an example of a prepayment penalty:
Loan amount: $500,000
Interest rate: 6.5%
Monthly mortgage: $2,708.33
6 monthly payments: $16,249.99
80% of 6 monthly payments: $13,000
Prepayment penalties are designed to protect lenders that rely on years of interest payments. Mortgages are granted with the assumption that interest payments will be collected over the life of the loan. It’s a simple concept: When mortgages are paid off early or refinanced, it cuts into the lender’s profits.
Why would I want a prepayment penalty on my mortgage?
Mortgages that feature a prepayment penalty offer lower rates than others, therefore making them attractive. If there is a chance that you may need to sell your home quickly or refinance, this is not the type of loan for you. FHA loans are an example of loans that do not carry any prepayment penalty.
Lenders and borrowers agree to the prepayment penalty, and it’s the lender’s job to communicate this to the borrowers and for the borrowers to fully understand the positive and negative potential consequences.
How do people prepay their mortgage?
There are several ways that people prepay their mortgage. The most common is paying a little extra every month. This small act can save thousands and even tens of thousands of dollars over the course of the loan. Another way people prepay their mortgage is by making bi-monthly mortgage payments instead of monthly. This adds one extra mortgage payment over the course of the year.
Most lenders that feature prepayment penalties enforce this for the first five years of the mortgage. If you are weighing your options between refinancing or prepaying your mortgage, make sure to know the key differences. Refinancing typically lowers your interest rate or shortens the length of the loan. Prepaying lowers the total amount and shortens the time of the mortgage. Evaluate what your goals are. If you're simply looking to lower your monthly payments, refinancing is probably the better choice. You might want to also consider your overall debt before prepaying your mortgage. If you have a lot of high interest credit card debt, it might be smarter to pay down that debt down first as your mortgage loan typically carries a much lower interest rate.
Be sure to do your due diligence and know the terms ahead of time. You don’t want to be surprised with high prepayment penalties, for example, if you need to sell quickly. Ask the lender questions about their prepayment penalties and be sure to understand the details. Armed with the right information, you can make the best decision for your financial situation in regards to a mortgage. This can save you a lot of money and headache down the road!