Prepayment penalty explained

What is a Prepayment Penalty?

A prepayment penalty is a fee charged by your lender if you pay off all or part of your mortgage before the end of the loan term. The fee is usually expressed as a percentage of the total loan amount and may be paid at closing or added to your outstanding balance.

How Does a Prepayment Penalty Work?

Prepayment penalties are typically charged on mortgages and other loans with fixed interest rates. They are designed to protect lenders from losing money on loans paid off early.

When you take out a loan, you agree to pay back the principal plus interest over a certain period of time. If you pay off the loan before the end of the term, the lender doesn’t have time to earn all of the interest they are entitled to. The prepayment penalty ensures the lender gets paid for the interest they would have earned if you had kept the loan for the full term.

Prepayment penalties are generally disclosed in the loan agreement. Be sure to read this document carefully before signing so that you understand all of the terms and conditions of your loan.

How Much is a Prepayment Penalty?

Prepayment penalties are typically a percentage of your loan balance, and can range from 2% to 5% of the loan balance. For example, on a $100,000 loan with a 5% prepayment penalty, you would owe a $5,000 penalty if you paid off the loan within the first five years.

When is a Prepayment Penalty Assessed?

Prepayment penalties are most commonly assessed when you refinance or sell your home before the end of your loan’s term. They can also be assessed if you pay off your loan with savings or by taking out a home equity loan.

The purpose of a prepayment penalty is to protect lenders from losing money if interest rates fall after you’ve locked in your rate. For example, say you take out a five-year fixed rate mortgage at 4% interest. Two years later, interest rates tumble to 3%. If you were able to refinance at that lower rate, your lender would essentially be stuck with a higher rate for the remaining three years of your term. To compensate for this risk, lenders charge a prepayment penalty.

In most cases, the fee is equal to three months’ worth of interest on your outstanding loan balance, though it can vary depending on the lender and type of mortgage. So, if you have a $300,000 mortgage at 4% interest and want to break your contract two years into your term, you’d owe a penalty of $2,250 (3 X $300 X 0.04/12).

You should avoid taking out a mortgage with a prepayment penalty clause if you think there is any chance you might want to refinance or sell your home before the end of your loan’s term.

Are There Any Exceptions to the Prepayment Penalty?

The short answer is yes, there are a few. The most common one is if you sell your house. You’ll also be off the hook if you refinance with the same lender (provided you qualify for the new loan), or if you die.

There are other circumstances in which your lender might agree to waive the penalty, but they’re much less common. If you have a good relationship with your lender, it couldn’t hurt to ask if they’d be willing to work with you. But don’t get your hopes up too high – in most cases, they’re going to stick to their guns and make you pay the penalty.

How to Avoid a Prepayment Penalty

If you have a mortgage with a prepayment penalty, you’ll want to avoid refinancing unless you’re positive rates have dropped enough to justify paying the fee.

Fortunately, there are ways to avoid paying a prepayment penalty. One is simply waiting until your term is up before refinancing. Another is negotiating with your lender; some are willing to waive the fee if you agree to stay with them for an extended period of time or increase the amount of your down payment. You can also look for lenders who don’t charge prepayment penalties in the first place.

What to Do If You Can’t Avoid a Prepayment Penalty

If you’re stuck with a prepayment penalty, there are a few things you can do to minimize the damage. First, try to negotiate with your lender. You may be able to get them to lower or waive the fee entirely. Second, refinance your loan as soon as possible. This will help you get rid of the prepayment penalty and potentially lower your interest rate as well. Finally, make sure you shop around for your next loan so you don’t end up in the same situation again.