Many people don’t seem to understand what a “prepayment penalty” is, much to their own detriment months or years after signing mortgage loan documents. This is especially true because it is often poorly explained, or not brought up altogether.
Instead, it’s buried in the paperwork and glossed over by borrowers who are eager to close on their mortgages and move on. Unfortunately, this can be a costly mistake if you happen to break the rules, whether you realize it or not.
There Are Two Types of Prepayment Penalties
A prepayment penalty, also known as a “prepay” in the industry, 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 mortgage 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 mortgage early can happen in a variety of different 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 being 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 will be subject to 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 after obtaining a mortgage.
How much does a prepayment penalty cost?
The prepayment penalty fee 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% of the loan balance each year, so the penalty only hits the borrower for 80%. 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, 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
So why the prepay, anyway?
Prepayment penalties were devised to protect lenders and investors that 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 than originally anticipated will be 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 your mortgage to ensure they get something back, regardless of how long the mortgage is kept before being paid off.
Watch Out for Prepayment Penalties!
Be careful when considering a mortgage with a prepayment penalty. While not as common today as they were in the early 2000s, they may still be tacked onto mortgages offered by portfolio lenders, who set their own rules.
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.
During the housing boom back in 2004-2006, most large banks like Wells Fargo didn’t charge prepayment penalties, but many smaller lenders usually did in order to compete on price with the larger banks. They were especially common in the subprime lending space.
Make sure you know what you’re getting before it’s too late! If you find out about an unwanted prepayment penalty late in the game, consider exercising your right of rescission.