What is a prepayment penalty?
Prepayment penalty is a provision in a mortgage contract that requires the borrower to pay a penalty if the mortgage is paid off within a certain time period.
A hard prepayment penalty is a penalty that’s assessed when the mortgage is paid off due to the borrower selling the home or refinancing the mortgage. A soft prepayment penalty only applies to mortgages that are refinanced.
Lenders include prepayment penalties in mortgage contracts to protect themselves from prepayment risks. Because investors buy mortgages to provide investment income, the unscheduled return of the mortgage’s principal means future interest payments won’t be paid to the investor.
While prepayment penalties are becoming less common, subprime mortgages often include prepayment penalties in their contracts. This is because the incentive for borrowers to refinance to lower interest mortgages is high.
Prepayment penalties vary. Some set a fixed percentage to be assessed and others use a sliding scale, assessing a smaller penalty based on how long the mortgage has been in place.
While some lenders assess a prepayment penalty if the mortgage is paid off within two years, others charge a fee if the mortgage is paid off within five years.
Mortgage lenders must disclose prepayment penalties at the time of the mortgage’s closing.
Prepayment penalty example
Stacy and Rick take out a $300,000 mortgage to buy a new home. Their mortgage contract includes a hard 4 percent prepayment penalty, requiring the couple to pay 4 percent of the remaining balance of the mortgage if they pay the loan off early by selling the home or refinancing the home within the next two years.
Six months after they buy their home, Rick loses his job. The only job he’s able to find is in another state. Stacy’s confident she can find work there, so they think it’s in their best financial interest to move.
The couple is faced with a dilemma. If they sell their home and pay off the mortgage before the 2-year period, they will have to pay a prepayment penalty of approximately $12,000.
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