What is a prepayment penalty?

Key takeaways

A prepayment penalty is a levy that discourages borrowers from paying off their loans ahead of schedule.Refinancing your mortgage or selling your house may result in this penalty.Soft prepayment penalties allow you to sell your house without paying a penalty, but harsh prepayment penalties apply regardless of whether you sell or refinance your mortgage.

Thinking about selling your house, refinancing your mortgage, or making extra mortgage payments? Any of these acts may result in a prepayment penalty from your mortgage lender, which may cost you thousands of dollars if you're not careful. Understand the workings of prepayment penalties and the potential charges.

What is a prepayment penalty?

A lender charges a prepayment penalty to prevent borrowers from paying more than their scheduled periodic payment or from fully repaying their loan in accordance with the terms of the loan agreement.

The good news is that most borrowers are no longer subject to a prepayment penalty, but you should confirm before getting or refinancing a mortgage, listing your house for sale, or attempting to pay off your mortgage early.

Why do lenders levy prepayment penalties?

Mortgage lenders and banks profit more when you pay off your loan over a longer period of time, such as a 30-year mortgage. That's because interest accumulates over the course of a loan. If you pay off your loan early by selling your property, refinancing to a new loan, or making extra principle payments, the lender will receive less interest.

"Lenders use prepayment penalties to incentivize people to keep the loan for more than a year or two," explains Kate Bulger, vice president of business development at Money Management International in Atlanta.

Types of Prepayment Penalties

There are two kinds of prepayment penalties: gentle and hard. In general, a soft prepayment penalty is more lenient than a heavy one.

Soft prepayment penalties.

If your loan has a light prepayment penalty, you can sell your home without incurring a penalty fee. We will use the proceeds from the sale to settle your mortgage, guaranteeing no penalty costs for the duration of your loan.

"A soft prepayment penalty would conform to the language of an agreed percentage penalty found in your mortgage loan documents," explains Charles Gallagher, a St. Petersburg, Florida-based attorney.

If you wish to refinance your loan, you will have to pay a prepayment penalty. A variety of criteria determine the prepayment penalty, so if you're considering refinancing, consult your lender about the penalty.

Hard prepayment penalties

When you sell your home or refinance your mortgage, you incur a hard prepayment penalty. You cannot refinance your loan or sell your residence without paying penalty costs. You may also face a prepayment penalty if you attempt to pay off more than 20% of your loan debt in any one 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 said.

If your mortgage includes a hefty prepayment penalty, paying it off early may not be the best financial move. You should consult with your lender about the exact fees to calculate how much you will pay in penalty fees vs. how much you will save in interest payments.

How much are the prepayment penalties?

Mortgage loans with early payment penalties are uncommon today, but when they do exist, the fees can be high. The penalty can be 2% of your loan total in the first two years and 1% in year three.

For example, suppose you wish to sell your property only one year after obtaining a non-conforming mortgage loan to buy it. Assume your remaining balance is $300,000. You will most likely incur a $6,000 prepayment penalty at closing, equivalent to 2 percent.

How does a prepayment penalty work?

The Dodd-Frank Act sets limits on prepayment penalties. A mortgage prepayment penalty is now only applicable during the first three years of the loan term.

When you shop around for a loan, Anna DeSimone, a New York City-based personal finance expert and author of "Housing Finance 2020," always discloses the penalty with your mortgage rate quote. "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.'"

If your lender issues you a prepayment penalty, you have to pay it all at once. When you refinance or sell your house, your lender assesses it and often deducts it from the closing proceeds.

An example of a prepayment penalty.

Here's an additional prepayment penalty situation: Assume you purchased a house 19 months ago and borrowed $200,000 through a non-conforming mortgage loan to finance it. Interest rates have decreased significantly, 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," said Bulger.

Another example: suppose you have a windfall and decide to utilize $30,000 to help pay off your $200,000 mortgage faster.

Bulger stated that there would be no prepayment penalty in this scenario. "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 the prepayment penalty

If you don't want to incur a prepayment penalty on your mortgage, follow these tips:

Shop the market: Compare rates from several lenders and avoid loans that charge a fee.Call your mortgage lender. Check with your lender to see if your current mortgage has a prepayment penalty.Negotiate a reduced prepayment penalty: If your mortgage has a prepayment penalty, try to work with your lender to reduce it.Plan your property sale, refinance, or accelerated payment scheme carefully. Timing these correctly will allow you to avoid paying penalties.