Prepayment penalties on a mortgage

Dear Dr. Don,
When refinancing, am I better off borrowing at 7.5 percent with no prepayment penalty or at 7 percent with a three-year prepayment penalty? Thanks. -- Corrine Conflicted

Dear Corrine,
It depends on how long you plan to stay in the house and the terms of the prepayment penalty. For example, the loan may be structured so there's no prepayment penalty if you sell your house, but there is a prepayment penalty if you refinance your mortgage.

Prepayment penalties stop the homeowner from shifting interest rate risk back to the lender. If rates go higher, the homeowner has little interest in refinancing, keeping the lender in a below market rate mortgage. Without a prepayment penalty, it's easier for refinancing to make sense for the homeowner, which stops the lender from realizing above market income on the original loan.

The loan with no repayment penalty has a higher interest rate to compensate the lender for the risk that you'll refinance when rates go lower, forcing the lender to reinvest at the new, lower interest rate.

Additional principal payments, especially if they're substantial, can trigger a prepayment penalty. Make sure you know the prepayment terms before making additional principal payments.

This Freddie Mac guide has more on prepayment penalty mortgages. In general, you should be comfortable with the interest rate on your new mortgage, expect to be in the house through the end of the prepayment period, and get enough of a break on the interest rate to make it worth your while before considering a mortgage with a prepayment penalty.

You'd want a bigger interest rate break to accept a five-year prepayment period then you would with a two to three year period. Conversely, you'd expect less of an interest rate differential if there's no prepayment penalty if you sell your home within the prepayment period.