What Is A Pre-Payment Penalty?
A prepayment penalty is a fee assessed to a borrower if they payoff their mortgage before a certain period of time has elapsed. (typically 2-5 years). This penalty can be stiff and equates to about 6 months of interest which is a little less than 6 mortgage payments not including your taxes and insurance.
Usually, a prepayment penalty will be reduced or disappear completely as time elapses. Seldom will you see a prepayment penalty that exceeds five years. Most lenders will allow a partial prepayment of the loan up to 20% of the balance in one year without any penalty being assessed.
A prepayment penalty can be “hard” or “soft.” “Hard” means that the penalty will be assessed whether you refinance or sell the home and “soft” means that the prepayment is forgiven in the event the buyer is selling the home, but charged if the buyer decides to refinance.
For example, on a $100,000 loan with 6.5% interest, a prepayment penalty based on 6 months interest would be $3,250. It’s not cheap. You may be able to get a tax deduction since it is considered prepaid mortgage interest, however, if you have to pay it during a refinance it reduces your home equity.
Lenders write prepayment penalties into mortgage loans to ensure that they get a certain yield off of the loan. Before the subprime implosion almost all of the subprime loans had prepayment penalties because the loans were so risky.
Prepayment penalties are seldom waived by the lender. The way most lenders view it is that you are terminating a relationship with them to begin a new relationship with another lender. With a lot of coaxing you may be able to induce the lender to let you out of the prepayment but it’s a long shot.
Every lender should disclose whether there is a prepayment penalty on the loan. Many borrowers find themselves wanting to refinance out of their high interest rate loan but soon discover there stuck because the fee to get out is so steep. It is often a surprise to most homeowners that there is a prepayment penalty on their loan. Their response is usually something along the lines, “My loan officer never mentioned anything about a prepayment penalty” or “My lender told me there was no prepayment fee.”
It is prudent that anyone getting a loan ask whether there is a prepayment penalty on the loan, and if so, how long it lasts. Next, you should ask the lender to show you where it specifically says in the contract that there is no prepayment penalty or show me the exact terms of the penalty if you decide to prepay the loan. As long as the prepayment matches you’re the time frame you plan on keeping the home, rarely is there a problem.
Prepayment penalties are fair IF you understand why it was added to your contract. If it’s assisting someone with marginal credit (assuming the home owner is now more responsible) become a new home owner, then it’s a fair deal. If it’s to pad a lenders pocket book then it’s FOUL.
One good thing when there’s no prepayment penalty you have the opportunity to refinance your home anytime you wish as long as the numbers work. You will need to find out how much does it cost to refinance a mortgage? so that you can make sure it is worth your time and actually lowers your payment.
