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Prepayment Penalty Pitfalls

Many homeowners don’t know what a mortgage Prepayment Penalty is until it’s too late. What is a prepayment penalty and is it something that you can avoid? Here’s what you need to know to make sure a prepayment penalty doesn’t sour the sweet refinance rates you’ve just locked down.

Prepayment Penalty Definiton

A mortgage prepayment penalty, also called a prepay, is a stipulation in your contract regulating when and how you’re allowed to pay off the loan. Mortgage lenders generally allow you to pay up to 20% of your loan balance every year.

You’re probably asking “Why on Earth would anyone want to pay off more than 20% of their loan balance in a year?!” Selling your home or getting lower refinance rates are common reasons for paying off the mortgage balance before the end of the term length.

There are two kinds of prepayment penalties that you need to be aware of. The types are hard and soft mortgage prepayment penalties. The soft prepayment penalty allows you to sell at any time without incurring a penalty; however, if you refinance your home loan you’ll be hit paying the fee.

The hard mortgage prepayment penalty socks it to you no matter what you do. It doesn’t matter if you sell, refinance or make a large equity payment greater than 20 percent, you’re going to get stuck paying the lender to get out from under your home loan.

How Much Will It Cost Me?

A typical prepayment penalty is 80% of six months’ worth of interest-only payments. Prepayment penalties vary by mortgage lender. The six-month’s interest is based on the interest only portion of your payment.

Suppose your mortgage was $350,000 at 5.5%. The interest-only payment is $1604 per month. Take 80% of six months of this payment and the prepayment penalty in this case is $7,699. This is a shocking expense to say the least, especially if you’re not expecting it.

Typical Prepayment Penalty Example:

  • $350,000 Mortgage
  • 5.5% Mortgage Rate
  • Interest Only Payment: $1,604
  • Six Months of Payments: $9,624
  • 80% Prepayment Penalty Amount: $7,699

How to Avoid Mortgage Prepayment Penalties

While accepting a prepayment penalty in your loan contract will typically get you lower refinance rates, it can bite you down the road when you decide to sell or refinance. Always check the fine print and ask your broker to make sure the contract doesn’t include the penalty. This is something that can be negotiated away when shopping for the lowest refinance rates.

If you’re considering an FHA mortgage this isn’t something you need to worry about as FHA home loans do not include prepayment penalties.

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