Considering selling your home, refinancing or making accelerated mortgage payments? Any of these actions could potentially trigger a prepayment penalty by your lender, which could set you back thousands of dollars if you’re not careful.
What is a prepayment penalty?
Prepayment penalty definition
A prepayment penalty is a fee charged by a lender 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 see if you’re subject to one before you get a mortgage, refinance, list your home for sale or attempt to pay off your mortgage early.
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 accelerated payments toward your principal, the lender won’t earn as much on that loan.
“Doing so deprives the lender of the expected interest over the term of the loan, and it also shortens the term of the loan,” says Charles Gallagher, an attorney in St. Petersburg, Florida.
Kate Bulger, director of business development for Money Management International in Atlanta, agrees.
“Lenders use prepayment penalties to incentivize people to keep the loan for more than just a year or two,” she says.
Types of loans with prepayment penalties
Fortunately, prepayment penalties are less common than they were years ago.
“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 Anna DeSimone, New York City-based personal finance expert and author of “Housing Finance 2020.”
DeSimone adds that a prepayment penalty is not necessarily a bad thing. You may have had to pursue a loan that comes with a prepayment penalty in order 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.
Gallagher adds that the Dodd-Frank Act prohibits most prepayment penalties for current residential home loans. However, they’re still allowed for loans that were executed before Jan. 10, 2014, he adds.
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,” DeSimone says. “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, it will be charged by and paid as a lump-sum fee to the lender. It is assessed upon the refinance or sale of your home and is usually collected from closing proceeds.
How much are prepayment penalties?
Although prepayment penalties are rare today, 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, let’s 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.
“Before the Dodd-Frank Act, prepayment penalties were even worse — often running anywhere from 3 to 5 percent,” Gallagher says.
Types of prepayment penalties
There are two types of prepayment penalties: soft and hard.
“A soft prepayment penalty is only assessed when you refinance your home. And it would conform to the language of an agreed percentage penalty found in your mortgage loan documents,” Gallagher says.
A hard penalty occurs when you sell your home or refinance.
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,” Bulger says.
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. But 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,” Bulger says.
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,” Bulger says. “That’s because your $30,000 accelerated payment is less than the 20 percent maximum your lender will allow annually as a prepayment amount.”
How to avoid a prepayment penalty
The best way to avoid a prepayment penalty is to take a pass on loans that impose the fee.
“Shop the market carefully with more than one lender and inquire around about different loan products,” Gallagher says. “Request a loan without a prepayment penalty, and read over the terms of your loan and paperwork thoroughly before signing it at closing.”
If you’re not sure if a prepayment penalty applies to your current mortgage, Bulger recommends calling your lender or servicer to ask.
If you learn that you may be subject to a prepayment penalty, find out all the details. Try to time a home sale, refinance or accelerated payment strategy carefully so that you can avoid paying any penalties.
“Also, call your lender and try to negotiate a lower prepayment penalty fee,” Bulger says. “They aren’t required to lower the penalty, but in some circumstances they may agree to a lower amount.”
Featured image by Mint Images of Getty Images.