What Is A Prepayment Penalty?
A prepayment penalty on a mortgage loan is a fee that can be charged by a lender when your mortgage is paid off in full or in part early. The penalty is imposed to encourage borrowers to pay their loan off over time so that lenders can collect interest.
Prepayment penalties normally do not apply to making extra payments, or large lump sum payments to pay down the principal balance. Most prepayment penalties only apply to paying off the loan completely – either through selling, refinancing, or otherwise paying down the loan in full.
Most mortgage lenders allow borrowers to pay up to 20% of the loan balance each year- and many lenders allow for larger payments so long as the borrower maintains a principal balance.
In other words, while lenders can charge a prepayment penalty, most 30-year mortgage lenders do not carry a prepayment penalty, but carry an Early Payoff Penalty.
Why Do Lenders Charge Prepayment Penalties?
Generally speaking, most individuals would want to be paid back as soon as possible. However, lenders generate profits by collecting interest, so they’d prefer to have a borrower keep their loan for as long as possible to collect many interest payments.
To break it down further, whenever a borrower hasn’t put significant money down when compared to the value of the house, the loan is at this riskiest stage. That’s why lenders will charge interest to mitigate their risk of no repayment. If the loan is paid off right away, lenders will lose out on any incentive they had to give the borrower the loan.
What Kind of Mortgages Have a Prepayment Penalty?
In today’s lending world, the good news is that most lenders do not charge a prepayment fee, but they may charge or incur an Early Payoff Penalty- more about that below.
Due to the Dodd-Frank Act, most lenders are prohibited from charging prepayment penalties on residential 30-year mortgage loans. It’s important tot keep in mind that they are still allowed for loans executed before January 10, 2014.
Non-Conforming mortgage loans – or Non-QM (nonqualified loans), are any loans that are not sold or insured by government-sponsored entities. These entities include Fannie Fae, Freddie Mac, the Federal Housing Administration, VA, and USDA home loans. It’s safe to assume that the loans not issued by these entities may carry a prepayment penalty that falls within the categories explained below.
How Much Are the Fees for Prepayment Penalties?
As might be expected, prepayment penalty costs vary. However, there are some typical structures for determining penalty costs:
- Sliding scale based on mortgage length: This is the most common penalty structure. For example, a 2/1 prepayment penalty. If the mortgage is paid off in the first year, 1% of the outstanding balance will be the prepayment penalty fee. If the loan is paid off during the first 2 years, 1 percent of the outstanding note will be the fee. On a $200,000 loan amount, the prepayment penalty would be $4,000 if the mortgage is paid off in the first year, or $2,000 if paid off during the 2nd year of the 30-year loan term.
- X number of months’ interest: This type of penalty would require a specific number of months’ interest. A common penalty would be 6-months of interest. For example, if you have a $500,000 mortgage loan at 6% interest, and the note is paid off early, the lender would charge a $ 15,000 fee.
- Percentage of remaining loan balance: This penalty will require a certain percentage, such as 2% or 3%, of the outstanding principal as a penalty fee if the payoff is made within the first 2 or 3 years of the loan term.
- Fixed amount: The lender will write a set figure, such as $6,000, for paying off a loan within the first year or six months – This is not a typical penalty for mortgages but may apply to other loans you may have.
Types of Prepayment Penalties
In general, there are two types of prepayment penalties: hard penalty and soft penalty.
Hard Prepayment Penalty:
This type of penalty can be incurred when you sell your home or refinance your home’s mortgage. Another way to incur this type of penalty is to attempt to pay off more than 20% of your loan balance in a given year.
Soft Prepayment Penalty:
A soft prepayment penalty is only assessed when you refinance your home, and it will abide by the language spelled out in your mortgage loan documents and is typically an agreed-upon percentage penalty.
Example of a Prepayment Penalty
Here is another example of a prepayment penalty scenario:
Let’s pretend that you bought a house in June 2021 – about 18 months ago. Your mortgage loan amount at that time was $200,000 via non-QM or non-confirming financing. Now, interest rates are declining far beyond the levels when you took out your loan, so you want to refinance it to enjoy a lower monthly payment.
In this scenario, since your refinance is falling within the 24-month prepayment penalty window, you would be charged a $4,000 prepayment penalty, or 2 percent of the loan balance. This is a soft prepayment penalty.
Another example is that you unexpectedly inherit $50,000 and want to apply that to your loan to help pay off some of the balance.
In this scenario, since your principal balance would be reduced by more than 20% within a year, you would incur a hard prepayment penalty.
However, if you were to pay off $30,000 of the loan instead, you would not incur a prepayment penalty since less than 20% is paid down.
How to Avoid a Prepayment Penalty Fee
The best way to avoid a prepayment penalty fee is to discuss all potential prepayment penalties before committing to the loan. If any of the loans you are discussing with your loan advisor do contain a prepayment penalty provision, it’s best to pass on the loan.
The CFPB, Consumer Financial Protection Bureau, allows borrowers to shop for mortgages by counting all mortgage-related inquiries within a 45-day window as a single inquiry to protect your credit scores. Being proactive with shopping for the right lender and loan is essential if you do not way to incur a prepayment penalty. Make sure to read over the terms of different loan products to make sure you understand your loan before signing the loan documents at closing.
If you learn that you are subject to a prepayment penalty after signing your loan documents, call your mortgage lender or servicer to ask for the specifics. Make sure you are paying attention to the timing of any refinance, sale, or principal reduction and that you strategize in a way that will allow for these actions without incurring the prepayment penalty fee.
Early Payoff Penalty
As mentioned in an earlier section, most conventional 30-year mortgages do not carry a prepayment penalty, but they might carry an early payoff penalty. It’s important to note that the biggest difference between these two penalties is that a prepayment penalty will be charged by the lender to the borrower. However, an early payoff penalty will be charged by the loan investor to the loan servicer. If a borrower pays off their loan early (within the first six months), the lender will be hit with an early payoff penalty, an EPO penalty. This penalty is charged by the investor to make up for lost interest payments.
Your lender may ask that you do not pay off your conventional mortgage loan within the first six months to avoid incurring this EPO penalty. EPO penalties can be quite high, usually in the 5-figure range, so it may be important to discuss this penalty with your lender as well so as to avoid hurting your mortgage lender by incurring this penalty that they will have to pay.