What is a prepayment penalty?
Prepayment penalties try to keep borrowers from refinancing, but not every lender charges them
In some scenarios, it can make sense to pay off a mortgage early. For example, paying more than the minimum payment on a mortgage helps homeowners reduce interest charges and get out of debt faster. Some homeowners may also opt to pay off their mortgage early through a refinance, which is when you trade your old home loan for a new one with different terms.
That said, some mortgage lenders charge prepayment penalties. If you want the option to pay off your mortgage at any time penalty-free, you should know all about mortgage prepayment penalties and how to avoid them.
Key insights
- Most new mortgages do not charge a fee for early prepayment, but some home loans still do.
- Mortgage prepayment penalties typically only come into play for the first few years of a home loan. After that, they phase out and borrowers can pay off their mortgage early penalty-free.
- The best way to avoid a prepayment penalty is to avoid lenders that charge one or to choose a government-backed mortgage.
Prepayment penalty definition
A prepayment penalty is a fee that can be charged to consumers who pay off their mortgage faster than the loan requires. The Consumer Financial Protection Bureau (CFPB) notes that prepayment penalties (on loans that have them) only apply for the first three to five years of a loan.
Check the fine print of a loan agreement for a prepayment penalty, including when it applies and how much it is.
Be aware that mortgage prepayment penalties should never take you by surprise. You should have agreed to the penalty being on your loan when you closed on your home, even if this information was buried deep in the terms and conditions of your mortgage note.
If you haven't taken out a mortgage yet but you're ready to purchase a home, now is a good time to check for prepayment penalties in an effort to avoid them. Finance expert Andrew Lokenauth, who teaches accounting, economics and finance as an adjunct professor at the University of San Francisco, says that consumers can avoid these unnecessary fees by carefully reviewing the terms of their loan agreement and negotiating with their lender.
Note that prepayment penalties typically apply only if you want to pay off your mortgage in full. If you want to put extra towards the principal in your monthly payment, then you likely will not be subjected to the penalty. It’s always a good idea to check with your lender first, though.
How does a prepayment penalty work?
When a mortgage has a prepayment penalty listed in its fine print, this penalty typically only applies during the first few years of the loan. However, many types of mortgages are legally prohibited from charging prepayment penalties, including all government-backed home loans. Loans that do permit prepayment fees must follow certain guidelines.
Some states also prohibit or limit prepayment penalties on home loans. This means that, depending on where you live, you may not have to worry about paying an early payment fee if you pay off your home quickly or refinance your mortgage before the term is up.
How much are prepayment penalties?
Per the Federal Deposit Insurance Corporation (FDIC), prepayment penalties can only be charged on a qualified mortgage with a fixed rate during the first 36 months. Further, the prepayment penalty can only equal a maximum of 2% of the outstanding mortgage balance during the first two years, and 1% of the outstanding balance during the third year.
A prepayment penalty typically applies if you pay off your loan within the first few years of the loan term.
For other types of loans that can charge these fees, including adjustable-rate mortgages (ARMs), the prepayment penalty may be higher. For example, the prepayment penalty on some loans may be 3% of the outstanding loan balance during the first year, then less than that in subsequent years, before ceasing to exist altogether after three to five years.
Generally speaking, this penalty is assessed when you pay off your loan early by making payments or refinancing. Because these penalties only apply during the first few years of having a mortgage, you don’t need to worry if you plan to make extra monthly payments that will not lead to paying off your mortgage completely within the first few years.
How can I avoid a prepayment penalty?
You can avoid paying a prepayment penalty on your mortgage by choosing a home loan that does not charge one. Many lenders that offer the best mortgage products don’t charge prepayment penalties. A good strategy is to ask upfront — before even applying for pre-qualification — whether the lender charges prepayment penalties on its loans.
Also note that you can avoid prepayment penalties by taking out a government-backed home loan, such as an FHA loan, a VA loan or a USDA home loan.
Finally, you can avoid prepayment penalties by reading the fine print on your mortgage and staying within guidelines that help you avoid them. This can mean waiting a few years before paying off or refinancing your mortgage so that the prepayment penalty period lapses first.
What kinds of loans come with prepayment penalties?
Most new mortgages don't have prepayment penalties; however, some do. For example, it's common to find prepayment penalties on subprime mortgages, large nonrecourse loans, alternative provider loans, investment property loans and some conventional loans.
Some interest-only mortgages and ARMs charge prepayment penalties, so make sure to check.
Why do lenders charge prepayment penalties?
Lokenauth, from the University of San Francisco, says a mortgage prepayment penalty is designed to compensate the lender for the interest it would have earned if the borrower had continued to make regular payments. By including a prepayment penalty, the lender discourages you from repaying the loan early, with the hope of collecting more money in interest.
Frequently asked questions (FAQ)
How can I negotiate a prepayment penalty?
While you can avoid prepayment penalties altogether by choosing a mortgage that doesn't include one, Lokenauth, from USF, says some lenders may be willing to budge on this fee upfront or later on.
"Some lenders may be willing to waive or reduce the penalty if the borrower can provide evidence of a significant change in their financial situation," he said.
When might a prepayment penalty be worth paying?
Paying a prepayment penalty could be worth it when the savings that result from paying off a mortgage work out to be more than the fee.
For example, if a borrower is required to pay a fee of 1% of their outstanding loan balance of $100,000 — or $1,000 — in order to refinance into a mortgage that will save them thousands of dollars over the next few decades, paying the fee could make sense.
Why is prepayment considered a risk?
Prepayment is considered a risk for a lender because it reduces the amount of interest it collects over the course of a loan. Prepayment penalties are used to maximize income on loans that borrowers pay off early.
Bottom line
If possible, you should avoid a mortgage that has a prepayment penalty. When you have a loan without a prepayment penalty, it’s an easier decision to pay off your loan early or refinance.
With that in mind, you should carefully read over the fine print in your home loan paperwork to check for a prepayment penalty. Don't be afraid to ask a loan officer about whether a prepayment penalty exists and how it works.
Sources
- Consumer Financial Protection Bureau, “ What is a prepayment penalty? ” Accessed Dec. 20, 2022.
- Consumer Financial Protection Bureau, “ Can I be charged a penalty for paying off my mortgage early? ” Accessed Dec. 20, 2022.
- Federal Reserve, “ A Consumer's Guide to Mortgage Refinancings .” Accessed Dec. 20, 2022.
- Federal Deposit Insurance Corporation, “ Interest-Only Mortgage Payments and Payment-Option ARMs .” Accessed Dec. 20, 2022.
- Federal Deposit Insurance Corporation, “ New Mortgage Rules Update .” Accessed Dec. 20, 2022.
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