Prepayment penalty
Many people don’t understand what a prepayment penalty is. A prepayment penalty, also known as a “prepay” is an agreement between the borrower and the lender that regulates what the borrower is allowed to payoff and when. Most lenders allow a borrower to payoff 20% of the loan balance off per year. You might be thinking why would anyone pay more than 20% 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 of course there is the standard large lump payment that a borrower could make that exceeds 20% in one year.
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 will 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!
