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When you have a mortgage, you might decide to refinance the loan or pay it off early to save money. But doing so may incur a prepayment penalty, which is a feature you should be aware of when comparing home loans.
Take a look at what a mortgage prepayment penalty is, what they might cost, and how to avoid them:
- What is a prepayment penalty?
- How much are prepayment penalties?
- Why lenders charge prepayment penalties
- How to avoid prepayment penalties
What is a prepayment penalty?
A prepayment penalty is a fee some mortgage lenders charge when you pay off all or part of your loan before the term ends. It’s an incentive for a borrower to pay off the mortgage over the full term so the lender earns interest.
Prepayment penalties normally won’t apply when you make a few extra payments here and there. Instead, prepayment penalties typically kick in when you pay off the entire loan early.
For example, you refinancing your mortgage, selling the home, or using a lump sum to pay off the loan, usually within three years, can trigger a prepayment penalty.
Types of prepayment penalties
There are two types of prepayment penalties — soft prepayment penalties and hard prepayment penalties. Here’s a quick breakdown of the two:
- Soft prepay penalty: Applies when you refinance the mortgage or pay off a large chunk of the balance. You can choose to sell your home or make larger payments to accelerate your payoff timeline without invoking the penalty.
- Hard prepay penalty: Applies if you refinance the mortgage, pay off a large portion of principal balance, or sell the home.
The type of prepayment penalty you’ll pay may depend on the type of mortgage you get and your lender’s practices.
Limits on prepayment penalties
On fixed-rate qualified mortgages, lenders can include a prepayment penalty clause during the first three years, with limits on the size of the fee. But they must also offer an alternative loan that does not include prepayment penalty fees.
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How much are prepayment penalties?
Prepayment penalties vary with each lender, but here are some typical formulas for determining this fee:
- Percentage of the outstanding loan balance: You may be required to pay a small percentage, such as 2%, of the remaining loan balance when paying off the loan within the first two or three years of the loan term. For example, if you owe $200,000 and the penalty fee is 2%, you pay a $4,000 prepayment penalty. Your lender may limit your prepayment penalty to a certain dollar amount, though.
- Interest for a certain number of months: Some lenders base the penalty fee on the amount of interest you would have paid had you kept the loan longer. For example, you might be required to pay six months’ worth of interest if you refinance.
- Flat fee: You might be required to pay a fixed amount, such as $2,000, for paying off the loan before the term ends.
- Sliding scale: This model is based on the length of the loan term. For example, if you pay off the mortgage within the first year, then you owe 2% of the outstanding balance; the penalty fee drops to 1% of the balance if you pay off the loan within the first two years.
Why lenders charge prepayment penalties
You might think all mortgage lenders want their money back ASAP. But when lenders issue mortgage loans, they expect to earn interest over the entire loan term, typically between 15 and 30 years. When borrowers pay back their mortgages before the term ends, they lose out on all of that interest.
How to avoid prepayment penalties
The best way to avoid prepayment penalties is to take out a loan that doesn’t carry any. Lenders can’t charge these fees on:
- FHA loans
- VA loans
- USDA loans
- Adjustable-rate mortgages
- High-interest mortgages
They can also choose not to charge this fee on conventional loans.
Check for a prepayment penalty
When you apply for a mortgage, the lender must give you a loan estimate within three days. This standardized document includes details about the loan, including the costs involved and whether any loan terms can change.
When you get the loan estimate, look at page 1 under the section “Loan Terms” / “Prepayment Penalty.” In the space under the question “Does the loan have this feature?” the document will say “yes” or “no.” If it says “yes,” then your loan has a prepayment penalty.
The loan estimate will also specify the amount of the penalty and when it may apply.