Considering selling your home, refinancing your mortgage or making extra mortgage payments? Any of these actions could potentially trigger a prepayment penalty from your mortgage lender, which could set you back thousands of dollars if you’re not careful. Learn what a prepayment penalty is, how it works and how much you might pay in prepayment penalty fees.

What is a prepayment penalty?

A prepayment penalty is a fee a lender charges to discourage a borrower from paying more than their scheduled periodic payment or completely paying off their loan under the terms of the loan agreement.

The good news is that most borrowers aren’t subject to a prepayment penalty nowadays, but it’s important to confirm before you get or refinance a mortgage, list your home for sale or attempt to pay off your mortgage early.

Why do lenders charge a prepayment penalty?

Mortgage lenders and banks make more money when you pay off your loan over a longer period, such as with a 30-year mortgage. That’s because interest accrues over the life of a loan. If you pay off your loan early by selling your home, refinancing to a new loan or making extra payments toward your principal, the lender won’t earn as much on that loan.

“Lenders use prepayment penalties to incentivize people to keep the loan for more than just a year or two,” says Kate Bulger, vice president of Business Development for Money Management International in Atlanta.

How much are prepayment penalties?

Mortgage loans with an early payment penalty are rare today, but when applicable, the fee can be steep. The penalty can be 2 percent of your loan balance within the loan’s first two years and 1 percent of your loan balance in year three.

For example, say you want to sell your home only one year after you took out a non-conforming mortgage loan to purchase it. Suppose your remaining balance is $300,000. At closing, you’ll likely be charged a prepayment penalty of $6,000, which amounts to 2 percent.

How a prepayment penalty works

The Dodd-Frank Act established limitations for prepayment penalties. Today, a mortgage prepayment penalty can only be assessed during the first three years of the loan term. Also, the penalties are capped at 2 percent of the loan balance for the first two years and 1 percent of the loan balance for the third year.

“The penalty is always disclosed with your mortgage rate quote when you shop around for a loan,” says Anna DeSimone, New York City-based personal finance expert and author of “Housing Finance 2020.” “Typically, you’ll see a statement such as ‘prepayment penalty fee equal to three months’ interest shall be paid in the event the mortgage is terminated within 12 months.’”

When you are assessed a prepayment penalty, you’ll have to pay it as a lump-sum to your lender. It is assessed upon the refinance or sale of your home and is usually collected from closing proceeds.

Example of a prepayment penalty

Here’s another prepayment penalty scenario. Say you bought a house 19 months ago and borrowed $200,000 via a non-conforming mortgage loan to finance it. Now, interest rates have dropped much lower, and you want to refinance to lower your monthly payments.

“In this case, because you are refinancing within the first two years of the loan, you would be charged a $4,000 penalty — equating to 2 percent of your balance,” says Bulger.

Another example: Imagine you inherit a windfall and decide to use $30,000 of it to help pay off your $200,000 mortgage more quickly.

“In this scenario, you would not be charged a prepayment penalty,” says Bulger. “That’s because your $30,000 accelerated payment is less than the 20 percent maximum your lender will allow annually as a prepayment amount.”

Which types of mortgages have prepayment penalties?

Fortunately, prepayment penalties are less common than they were years ago. The Dodd-Frank Act prohibits most prepayment penalties for current residential home loans, but they’re still allowed for loans that were executed before Jan. 10, 2014, according to Charles Gallagher, an attorney in St. Petersburg, Florida.

“They’re associated with non-conforming mortgages — loans not sold or insured by government-sponsored enterprises such as Fannie Mae or Freddie Mac — and they don’t apply to conventional, FHA, VA or USDA home loans,” says DeSimone.

A prepayment penalty is not necessarily a bad thing, says DeSimone. You may have had to pursue a loan that comes with a prepayment penalty to get financing. For example, if you are self-employed and run a small business with less than a two-year history required by conventional lenders, you might have to get a non-qualified mortgage that comes with a prepayment penalty.

Types of prepayment penalties

There are two types of prepayment penalties: soft and hard. In general, a soft prepayment penalty is more forgiving than a hard prepayment penalty.

Soft prepayment penalties

If your loan has a soft prepayment penalty, it means you can sell your house without paying a penalty fee. The proceeds from the transaction will go toward paying off your mortgage, and you won’t pay any penalty fees, no matter how much time is left on your loan.

“A soft prepayment penalty would conform to the language of an agreed percentage penalty found in your mortgage loan documents,” says Gallagher.

If you decide to refinance your loan, however, you do have to pay a prepayment penalty. The prepayment penalty will depend on various factors, so it’s important to talk to your lender about the penalty fees if you’re thinking about refinancing.

Hard prepayment penalties

A hard prepayment penalty occurs when you sell your home or refinance your mortgage. You aren’t able to refinance your loan or put your house on the market without paying penalty fees. You can also incur a prepayment penalty if you attempt to pay off more than 20 percent of your loan balance in any given year.

“Making a few extra payments toward your principal or paying a little extra every month usually isn’t enough to trigger a prepayment penalty,” says Bulger.

If your mortgage has a hard prepayment penalty, paying off your mortgage early might not be the best financial decision. You should ask your lender about the specific fees to determine how much you’ll pay in penalty fees versus how much you’ll save in interest payments.

How to avoid a prepayment penalty

If you don’t want to pay a prepayment penalty on your mortgage, consider these tips to avoid the fee:

  • Shop the market: Shop around with different lenders, and pass on loans that impose the fee.
  • Call your mortgage lender: Ask your lender if a prepayment penalty applies to your current mortgage.
  • Negotiate a lower prepayment penalty: Try to negotiate a lower prepayment penalty with your lender if one does apply to your mortgage.
  • Time a home sale, refinance or accelerated payment strategy carefully: Timing these carefully will help you avoid paying any penalties.