Many people don’t understand what a “prepayment penalty” is, much to their own detriment months or years after signing mortgage loan documents.
A prepayment penalty, also known as a “prepay”, is an agreement between a borrower and a bank or mortgage lender that regulates what the borrower is allowed to pay off and when. Most lenders allow borrowers to pay off up to 20 percent of the loan balance each year.
At this point, you might be wondering why would anyone pay more than 20 percent of their home loan off in one year? Well, thinking outside the box a bit, paying off a loan can happen in a variety of ways.
If you sell your home, that is one way to paying off the loan in full. And if you refinance the loan, you effectively pay off the mortgage as well by replacing it with a shiny new one. Oh, and one large lump payment could exceed that 20 percent mark in one year as well.
That said, it is important to note that there are two types of prepay penalties. These include “soft prepayment penalties” and “hard prepayment penalties.”
A soft prepayment penalty allows a borrower to sell their home at anytime without penalty, but if they choose to refinance the mortgage, they must pay the prepayment penalty.
A hard prepayment penalty, on the other hand, sticks the borrower with a penalty if they sell their home OR refinance their mortgage. Obviously this is the tougher of the two, and basically gives a borrower no option of jumping ship if they need to sell their home quickly.
How much does a prepayment penalty cost?
The prepayment penalty is often 80% of six months interest. It can vary, but in our example it is 80% because the lender allows the borrower to pay off 20% per year, so the penalty only hits the borrower for 80% of the loan. The six months interest is the interest-only portion of the mortgage payment the borrower secured when they took out the mortgage.
So if a borrower has a mortgage rate of 6.5% on a $500,000 loan amount, their interest-only payment comes out to $2708.33 per month. Multiply that by six months, and take 80% of the total, and you end up with a hefty prepayment penalty of $13,000.
An example of a prepayment penalty:
$500,000 loan amount
Interest rate of 6.5%
Monthly mortgage payment of $2,708.33
6 monthly payments = $16,249.99
80% of those 6 monthly payments = $13,000.00
Watch Out for Prepayment Penalties!
Be careful when considering a mortgage with a prepayment penalty.
Although a mortgage with a prepayment penalty may come with a much lower interest rate, it can come back to haunt you if you need to refinance earlier than planned, if mortgage rates drop significantly, or if you decide to sell your home earlier than you anticipated.
Most larger banks like Wells Fargo don’t tack on prepayment penalties, but many smaller lenders usually tack them on to compete with larger banks. They are especially common in the subprime lending arena.
Make sure you know what you’re getting before it’s too late! If you find out about one late in the game, consider exercising your right of rescission.
So why the prepay?
Prepayment penalties were devised to protect lenders and investors who rely on years and years of lucrative interest payments to make money.
When loans are paid off quickly, regardless of whether by refinance or a sale, less money is made. It’s a simple concept. The mortgage is extended with the belief that a certain amount of interest will be collected. If, in reality, much less is realized, the holders of these mortgages won’t profit as they originally expected. So it’s clearly less desirable for those who hold the loan.
This is essentially a way for those with an interest in the mortgage to ensure you they get something back, regardless of how the mortgage is paid off.
Tip: There are no prepayment penalties on FHA loans, which is one of their many advantages.