Prepayment penalty
Many people don’t understand what a prepayment penalty is, much to their own detriment months or years after signing loan documents. A prepayment penalty, also known as a “prepay”, is an agreement between a borrower and alender 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 thinking 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. If you refinance the loan, you effectively pay off the loan. 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. There are 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 6 months interest. It can vary, but in this 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 6 months interest is the interest-only payment the borrower secured when they took out the mortgage. So if a borrower has a rate of 6.5% on a $500,000 mortgage, their interest only rate is $2708.33 per month. Multiply that by six months, and take 80% of the total, and you end up with a hefty fine of $13,000.
$500,000 loan amount
Interest rate of 6.5%
Monthly payment of $2,708.33
6 monthly payments = $16,249.99
80% of those 6 monthly payments = $13,000.00
So be careful when considering a loan with a prepayment penalty. Although it will often come with a much better rate with many lenders, it can come back to haunt you if you need to refinance earlier than planned, if rates drop significantly, or if you decide to sell your home. Most larger banks like Wells Fargo don’t tack on prepayment penalties but smaller lenders usually will to compete with larger banks. Make sure you know what you’re getting before it’s too late!
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, less money is made, so it’s clearly less desirable for those who hold the loan. It’s for this reason that prepays are tacked onto loans.
