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Guide to Penalties for Early Home Loan Payment

Guide to Understanding Mortgage Prepayment Penalties

Man shocked looking at a big bill.

Paying loans ahead of time is often considered a good practice. It shows you’re a trustworthy borrower who can manage finances well. Considering how much you’ll save on interest, it makes sense to pay off debt sooner than expected.

But wait right there. Some lenders actually apply penalty fees if you pay off your loan too early. If you’re not aware, you’ll end up spending a huge sum. For this reason, it’s crucial to understand mortgage agreements before rushing to sign a contract.

What’s prepayment penalty and how does it work? In this article, we’ll explain how borrowers are charged for paying off their mortgage too quickly. We’ll talk about its costs and different ways you can avoid. Then, we’ll discuss when paying a prepayment penalty may be worth it.

What is a Prepayment Penalty?

AIn mortgage, prepayment penalty is a fee lenders charge if you pay down your entire loan before the agreed term ends. It is likewise applied when you pay a significant part of your loan earlier. Prepayment penalty is usually a clause that states you must pay a fee if you make a large payment or early full payment within the first 3 to 5 years of a loan.

How Penalties are Assessed Vary By Lender

Penalties may be based on the number of months and its equivalent interest charges. Some are based on the remaining principal balance. Other lenders may use a sliding scale payment which factors how long you’ve been paying the mortgage.

Even if you don’t pay off the entire loan, there are lenders that prompt prepayment penalty charges. This happens if you pay off a large portion of your outstanding balance in a single payment.

How is it calculated? Early payment penalties vary per lender. Here are examples of how lenders estimate your penalty fee:

  • Percentage of the loan balance – For example, if your principal balance is $100,000, and the penalty percentage is 2 percent, you’ll pay $2,000. Likewise, the amount is larger if your remaining balance is higher. For instance, if your balance is $470,000 and you must pay a 2 percent penalty fee, the cost will be $9,400. At almost 10 grand, you must decide whether it’s worth it to pay it early.
  • Based on interest costs – Here, the penalty is based on how much interest a lender is supposed to earn if you maintained the original payment schedule. Since calculations vary, some lenders might require 6 months worth of interest. For instance, let’s suppose your outstanding balance is $350,000 at 4 percent rate with monthly payment at $1,670.95. If we use an amortization calculator, interest cost per month is about $1,156.50 on the second year. If we multiply this by 6 months, the penalty cost will be roughly around $7,000.
  • Sliding scale based on term length – An example is a a sequential 2/1 prepayment penalty which covers the first 2 years of the loan. If the mortgage is prepaid in the 1st year, the penalty will be 2 percent of the outstanding balance. If the mortgage is prepaid in the 2nd year, the penalty becomes 1 percent of the balance. For instance, if your remaining balance is $250,000 and you pay down your mortgage within the 1st year, you must pay a $5,000 penalty. If you pay off your mortgage within the 2nd year, you must pay a $2,500 penalty.
  • Fixed payments – Other lenders simply charge a flat fee for paying off loans early. This is not usually applied to mortgages. For instance, some banks such as Wells Fargo charge around $500 if you prepay a home equity line of credit (HELOC) in under 3 years.

How Much Does Prepayment Penalty Cost?

Ideally, prepayment penalties should not cost over 2 percent of your outstanding balance. For example, if your outstanding balance is $350,000, prepayment penalty should not go over $7,000. However, depending on your lender and when you obtained your mortgage, penalty fees may cost as much as 3 percent of your remaining balance.

Types of Prepayment Penalties

Selling Your House.

Prepayment penalties are not limited to paying your loan early. They are largely associated with selling your home or refinancing your mortgage. Prepayment penalties come in two main types:

Soft Prepayment Penalty

This penalty is only assessed for refinanced mortgages. It allows borrowers to sell the house any time without penalty fees. However, if you choose to refinance the mortgage, you must submit to prepayment penalty.

Example scenario
What: Refinancing a recent mortgage
When: During the 2nd year of the loan term
Why get a penalty: Under soft prepayment penalty, you cannot refinance a mortgage within the first 3 years.

Hard Prepayment Penalty

Let’s say you want to refinance your 2-year mortgage. It’s a great opportunity because rates are almost two percentage points down. You do this despite agreeing to soft prepayment penalty within the first 3 years of the loan. Your lender will require a 2 percent fee based on your outstanding balance. If your balance is $300,000, you must pay a penalty fee of $6,000. However, if you sell the house and pay your remaining balance with profits from the sale, you don’t pay the fine.

This penalty is assessed for both refinanced mortgages and sold houses. A hard prepayment penalty prohibits a borrower from selling the house or refinancing within the first few years of the loan. It gives you no other option if you need to sell your home after securing the loan.

Example scenario
What: Selling a new house
When: During the 3rd year of the loan term
Why get a penalty: Under hard prepayment penalty, you cannot sell your house or refinance the mortgage within the first 3 years.

Let’s suppose you’ve been living in a house for 3 years. Suddenly, you need to move because of work. Under hard prepayment penalty, you must pay the fee if you sell the house within 3 years of the mortgage contract. For instance, your lender imposes 6 months worth of interest charges. Let’s say your balance is $300,000 with a 4 percent rate. If your estimated monthly interest charge is around $982.39, your penalty fee will be almost $6,000. You’ll pay the same fee if you decide to refinance your mortgage.

What About Small Extra Payments Toward my Principal?

According to the Consumer Financial Protection Bureau (CFPB), prepayment penalty does not usually apply to small extra payments. However, ask your lender first. Some may actually impose prepayment penalty with small extra payments. For instance, they may allow you to pay up to 20 percent of your balance in extra payments. After this, you need to pay the penalty fee.

Why is Prepayment Penalty Applied?

When you pay a loan early, the lender does not earn as much interest. They cannot profit from interest charges you agreed to pay in the original loan term. It’s applied so lenders can recoup the cost of the mortgage before a homebuyer refinances or pays it off.

The penalty helps protect lenders from the financial cost of losing interest income. It offsets their prepayment risk, especially during difficult economic periods where homeowners refinance mortgages at much lower rates (though during the 2020 coronavirus pandemic, consumers generally had a hard time refinancing). Penalties protect lenders from high-risk borrowers (with low credit scores and unsavory credit histories) who may refinance or pay down their loan within the first 5 years of the mortgage.

There were times, however, when lenders applied prepayment penalties at punitive costs. Prior to the 2008 U.S. housing financial crisis, prepayment penalties were a common practice. Back then, it was normal to get a prepayment penalty worth 6 months of interest based on 80 percent of the principal balance. For instance, if you had a $500,000 loan with an 8 percent interest rate (the common rate at the time), prepayment penalty would cost around $16,000. That’s around 3.2 percent of your outstanding balance. This is a hefty sum, which is a huge expense on top of closing costs. Because of exorbitant fees, prepayment arrangements had to be regulated.

Protection from Unfair Lending Practices

House Protected by a Large Umbrella.

To protect consumers, the CFBP amended Regulation Z of the Truth in Lending Act. This covers the consumer’s ability to repay along with qualified mortgage standards (QMs). Under the revised law, there are limits to the amount lenders can charge for prepayment penalties on certain types of mortgages. The law generally requires lenders to make reasonable, good faith judgments of borrowers’ ability to repay loans secured by property.

Ask for Alternative Loans with No Prepayment Penalty

Lenders who offer loans with prepayment penalty are required to offer alternative loans. Ask about this if your lender did not provide any. They must offer another option in case you highly qualify for a loan without prepayment penalty.

When are Prepayment Penalties Allowed?

Under the 2014 revised law, prepayment penalties are allowed if the following conditions are met:

1

If the mortgage’s APR is not subject to increase, such as a fixed-rate loan.


2

If the loan is a qualified mortgage (QM) – This is a type of mortgage with more stable terms, making it affordable for borrowers. It’s usually a fixed-rate mortgage with a 30-year term. The loan should not have risky features such as interest-only payments or negative amortization.

3

If it is not a higher-priced mortgage – This is a type of mortgage with an annual percentage rate that’s higher than the Average Prime Offer Rate (APOR). APOR is a benchmark based on average interest rates, fees, and other mortgage terms offered to qualified borrowers with high credit ratings.

Take note, however, that the revised prepayment penalty rules do not apply to pre-2014 mortgages.

For majority of home loans after January 2014, lenders can only apply prepayment penalties during the first 3 years of a loan. The maximum penalty allowed is up to 2 percent. You pay 2 percent of your outstanding balance if you prepay the loan within the first 2 years. It goes down to 1 percent if you prepay it in the third year.

Today, not all creditors impose prepayment penalties. There are states that prohibit lenders from applying them. However, since other banks are regulated by federal law, they may still impose prepayment penalties without adhering to the amended law. It’s best to check with your lender to know for sure.

Lenders are required to disclose prepayment penalty terms before closing a deal. No mortgage penalty can take effect without your knowledge or approval. Be sure to read the fine print carefully before signing a mortgage contract.

Types of Mortgages without Prepayment Penalties

Most government-backed mortgage loans do not impose prepayment penalties. These programs are known to help consumers afford houses with low or zero down payment options. These mortgages include Federal Housing Administration loans (FHA), U.S. Department of Agriculture (USDA) loans, and U.S. Department of Veterans Affairs (VA) loans. Apart from mortgages, even student loans do not impose early payment penalties.

Meanwhile, conventional mortgages and jumbo loans may have prepayment penalties. You must talk to your lender to clarify if your loan comes with this arrangement. Take note: Certain conventional mortgages such as fixed-rate loans and other qualifying mortgages (QMs) must abide by the amended Regulation Z of 2014. In some instances, if an adjustable-rate conventional loan qualifies under QM, it should not have a prepayment penalty.

How to Avoid Prepayment Penalty

Man consulting a female banker about how mortgage.

The best way to avoid prepayment penalty is to obtain a mortgage deal without one. But for many homeowners who already have it in their mortgage, there are ways you can avoid it triggering it. You can do this by reviewing the terms of your mortgage and asking your loan servicer for the specific rules set by your lender.

Before Closing a Mortgage

When negotiating with your lender, specify that you do not want a prepayment penalty in your mortgage. Though lenders should inform you, sometimes they might overlook this clause. Prepayment penalty details should be included in your loan estimate as well as your closing documents. When you review your contract, keep an eye on the disclosure details, specifically under the ‘Addendum of Note.’ Read the contract carefully for any addendum which may pertain to prepayment penalties.

Ideally, lenders should provide an alternative loan without prepayment penalty. However, if they are unable to offer one, ask your lender for a similar quote without it. If you are unsatisfied with the offer, you can always move on to another lender.

You Can Negotiate Prepayment Penalties Down

If you’re confident you won’t be selling or refinancing your home within 3 or 5 years, getting a prepayment penalty clause shouldn’t be so bad. You can even try negotiating it down. For instance, instead of 5 years, ask if they can shorten it to 3 years.

Mortgages with prepayment penalty may allow slightly lower rates and upfront costs. Loan servicers also prefer them because they get a slightly higher commission. If you spend most of your money on down payment, accepting a loan with prepayment penalty may help ease mortgage fees a bit and reduce closing costs.

Before you agree, make sure to ask the following questions:

  • How long does it take effect?
  • What situations require a penalty payment?
  • Is it prompted when the house is sold, refinanced, or both?
  • Does it include partial payments or only full payments?
  • For partial payments, how much can you pay off before the penalty is prompted?
  • How much is the fee and how is it calculated?

Existing Mortgage with Prepayment Penalty

If you have a loan with prepayment penalty, your best recourse is to learn what will and will not trigger the penalty fee. Go over your closing documents, billing statements, and any files that breaks down your prepayment penalty terms. While you’re at it, talk to your lender to clarify when penalty fees will be applied. More importantly, ask how much it will cost. If you weren’t able to ask the questions in the previous section, now is the time to do so.

The following are strategies you can do to avoid prepayment penalty:

  • Wait Until the Penalty Expires – Once you know when it expires, you can time dates to arrange refinancing. Just keep in mind lenders do not always update your records on time. Inform your lender and wait for them to update your statement. In other cases, some borrowers who prompt the penalty fee just pay it partially per month until the penalty date passes.
  • Sell the House if You Have a Soft Prepayment Penalty – Again, penalties are not assessed when you sell your house under soft prepayment penalty. But if you have a hard penalty, it might be best to sell it right after the clause expires.
  • Try to Refinance with Your Current Lender – Sometimes the same lender may allow you to refinance your mortgage without assessing the penalty fee. This is not common, but it won’t hurt to try and negotiate. If they do, that will save you thousands of dollars. However, don’t be surprised if your lender imposes a prepayment penalty on the new mortgage.

Make Time to Estimate the Cost

In the event you do sell your house or refinance your home, you should estimate the cost. This will help you evaluate whether paying the penalty fee is worth it.

Man sitting at his computer thinking of refinancing his home.

To give you an idea, read through the example scenario which involves refinancing below.

Let’s suppose you have a prepayment penalty that covers the first 5 years of your mortgage. You want to refinance your mortgage in the 3rd year because rates are almost 2 percentage points lower. Your lender assesses the penalty fee based on 3 percent of your outstanding balance.

If your outstanding balance is $450,000, your penalty fee will be $13,500. On top of this, refinancing is typically 3 to 6 percent of your outstanding balance. With prepayment penalty, it doubles the cost. On the other hand, to avoid the high penalty cost, it’s worth refinancing after the penalty has expired.

In another scenario, let’s say your principal balance is lower at $370,000. Given the same prepayment penalty clause, you’ll pay $11,100 if you decide to refinance on the 3rd year. This is around $2,400 less compared to the previous penalty fee.

Before you sell or refinance your mortgage, it’s worth considering if you can still lower your outstanding balance. It shows how waiting another year or two can reduce your principal, which also reduces the prepayment penalty.

Likewise, there’s no guarantee mortgage rates will be as low the following year (or even after the penalty has expired). Nonetheless, if you’re decided on much lower mortgage rates while incurring a lower penalty fee, it could be worth the risk. But again, it would not be as costly if you refinance after the penalty period expires. In this case, it’s likely better to refinance once the penalty expires.

For more helpful advice on refinancing, read our guide on the costs of refinancing.

Know the Estimated Costs Before Refinancing

Weighing in the expenses should help you decide if you’re ready to refinance during or after a penalty period. In the long term, refinancing to much lower rates will help ease your cash flow and lower your overall interest charges.

The Takeaway

Mortgage prepayment penalties are an added expense when you need to sell or refinance your home early into the term. It can offset possible interest savings if you pay down your loan early.

However, in 2014, the government has set rules to help regulate lenders that impose punitive prepayment penalties. While lenders still offer contracts with prepayment penalty, many of them should not exceed more than 2 percent of a borrowers outstanding balance.

If you’re looking for a new mortgage, it pays to make sure your contract does not have prepayment penalty. If your existing loan has one, it helps to sell your home or refinance once the penalty expires. However, if you really cannot avoid it, it’s worth calculating how much funds you need to prepare for the cost.

Ashburn Homeowners May Want to Refinance While Rates Are Low

US 10-year Treasury rates have recently fallen to all-time record lows due to the spread of coronavirus driving a risk off sentiment, with other financial rates falling in tandem. Homeowners who buy or refinance at today's low rates may benefit from recent rate volatility.

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