While not as common as they were just a few years ago, there are still many loan programs that give borrowers the option of paying a penalty. When a mortgage has this penalty, it means the borrower agrees in writing that if the mortgage is "prepaid" before a specific amount of time, often less than 5 years, the borrower agrees to pay a penalty to the lender.
Most mortgages today do not come with a prepayment penalty. Some loans, including an FHA loan, VA loan or USDA loan, never include a prepayment penalty. These government-backed mortgages allow you to pay off your loan at any time, or make extra payments, without paying a penalty.
Many homeowners, however, do discover that their second mortgage or primary mortgage has a prepayment penalty. When housing prices rose and borrowers looked for the cheapest way to finance a home purchase, banks used prepayment penalties to lure in buyers with low rates.
Banks often lowered the rate by about one quarter of a percent in exchange for requiring the borrower to pay a penalty if the mortgage was paid off in a set period of time, often between 3 and 5 years.
When a lender provides you a mortgage, they will calculate their expected return on investment into their model. This includes calculating the amount of time you must have the mortgage before it prepays.
The most common reason a borrower prepays a loan, or pays it off early, is because they found a loan through another lender with a better interest rate and refinanced out of the current mortgage.
Prepayment penalties, when they do exist, are usually between 2 and 4 percent of the loan. On a $200,000 mortgage, a 2% penalty amounts to $4,000. Some prepayment penalties are a fixed fee, while others are on a sliding scale that decreases the longer the loan is held.
Some lenders require the penalty only in certain situations, such as if you sell your home, but some require the penalty regardless of the circumstances.
Are Prepayment Penalties Bad?
Prepayment penalties are not necessarily a bad thing, if you are aware of the penalty, understand what it means, receive a lower rate or closing costs and have a choice in the matter.
In some situations, it is worth accepting a prepayment penalty to move into a lower interest loan through refinancing as well. If you must pay a prepayment penalty of $4,000 to refinance and save $50,000 over 15 years, the cost may be worth it. The penalty can also be worth it to get out of a balloon loan.
The good news is prepayment penalties have been eliminated by most mortgage lenders on most products. Lenders typically allow you to pay off your loan early at no cost. Without a prepayment penalty, you may refinance without facing a financial penalty, or make extra monthly payments to shave years off of your loan.