What is a Prepayment Penalty?

A prepayment penalty is a fee that some lenders charge if you pay off all or part of your mortgage early. If you have a prepayment penalty, you would have agreed to this when you closed on your home. Not all mortgages have a prepayment penalty. The penalty is sometimes based on a percentage of the remaining mortgage balance, or it can be a certain number of months’ worth of interest. For example, because you sold your home or are refinancing your mortgage – within a specific number of years (usually three or five years).

In some cases, a prepayment penalty could apply if you pay off a large amount of your mortgage all at once. Prepayment penalties do generally not apply if you pay extra principal on your mortgage in small chunks at a time–but it’s always a good idea to double-check with the lender. Prepayment penalties protect the lender against the financial loss of interest income that would otherwise have been paid overtime.

How does a prepayment penalty work?

Prepayment penalties are written into mortgage contracts by lenders to compensate for prepayment risk, particularly in difficult economic climates and under circumstances where the incentive for a borrower to refinance a subprime mortgage is high. The Dodd-Frank Act established limitations for prepayment penalties. Today, a mortgage prepayment penalty can only be assessed during the first three years of the loan term. Also, the penalties are capped at 2 percent of the loan balance for the first two years and 1 percent of the loan balance for the third year.

Types of prepayment penalty

That being said, it is essential to note that there are two types of prepaying penalties. These include soft prepayment penalties and hard prepayment penalties. A soft prepayment penalty allows a borrower to sell their home at any time without penalty. Still, 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. This is the tougher of the two and gives a borrower no option of jumping ship if they need to sell their home quickly after obtaining a mortgage.

Most prepays only last 1-3 years, but if you need to refinance or sell your home unexpectedly, the prepayment penalty can be quite severe.

How to avoid a prepayment penalty

The best way to avoid a prepayment penalty is to take a pass on loans that impose the fee. If you’re not sure if a prepayment penalty applies to your current mortgage, then it is best to call your lender or servicer to ask. If you learn that you may be subject to a prepayment penalty, find out all the details. Try to time a home sale, refinance, or accelerated payment strategy carefully so that you can avoid paying any penalties.