what is it and how to avoid it

Do you know that you can be charged prepayment penalty for trying to pay off your loans ahead of time?

A prepayment penalty is a fee that some lenders charge when you refinance or pay off your mortgage early. Not only are they fairly common – they are often misunderstood by borrowers.

In this article, we’ll discuss how mortgage prepayment penalties work, what types of prepayment penalties you may face, and how to avoid paying them.

How Prepayment Penalties Work and Why Lenders Charge Them

Your monthly mortgage payment consists of principal and interest payments. Principal payments pay off your loan, while interest payments go to your lender. When you take out a loan, your lender expects to make money on those interest payments. Lenders include prepayment penalties in mortgage contracts to make you think twice before refinancing or paying off your loan prematurely.

Let’s say you withdraw $250,000 fixed for 30 years at 5% interest. If you don’t increase or pay additional mortgage payments at the end of 30 years, your total loan cost is $483,165. $250,000 for principal and $233,165 in interest.

However, if you suddenly run into money and decide to pay off your loan after two full years, your lender will only receive $22,619.43 in total interest payments. If you pay off half of your loan balance instead, this cuts into how much interest you have to pay and your lender’s profits.

Thankfully prepayment penalties are becoming less common. Also, your mortgage lender is required to notify you if they are involved in your closing paperwork. If your lender doesn’t, they can’t charge you a fee for them if you refinance your loan or pay it off early.

Are there limits on prepayment penalties?

The Dodd-Frank Act placed limits on prepayment penalties to protect property owners from sticker shock. Lenders can only levy mortgage prepayment penalties during the first three years of your loan term. They can charge a maximum of 2% of your loan balance during the first two years of your loan and 1% during the third year.

If you are charged a mortgage prepayment penalty during this period, you pay a one-time fee when you sell or refinance your home.

Also, if you have an FHA loan, USDA loan, or VA loan, federal law prevents lenders from charging prepayment penalties. Student loans are also exempt from these fees.

Examples of Prepayment Penalties

Let’s say you take out a 30-year mortgage loan on a $300,000 property with a 5% fixed interest rate. A little over a year later, your home skyrockets to a new market value of $350,000, so you decide to sell it, even though your lender notified you of the prepayment penalty clause in your contract.

At this point, you still owe $295,000. Since you’re selling within the first two years of ownership, your lender charges you a 2% prepayment penalty of $5,900 ($295,000 x 2%). If you wait until your third year, the penalty is reduced to 1%, or $2,950. After accounting for closing fees and the real estate agent’s deduction, is it worth it to hold onto a home a year or two to reduce or eliminate your prepayment penalty? It all depends on your circumstances.

Let’s say you decide to refinance your loan at 4% instead. At 5%, you’d pay $279,767 in total interest over 30 years. At 4%, you’ll pay $215,609 in total interest, a difference of over $64,000 (excluding interest you’ve already paid to your current lender). It also saves you about $180 on your monthly mortgage payment.

If your prepayment penalty is the same as in the first example ($5,900), you can earn the money back for the fee in about 33 months ($5,900 / $180). If rates stay at 4%, it’s likely to wait a year or two – but not always. Rates can fluctuate constantly, so deciding whether or not you should refinance depends on how much you’ll be saving over the long term.

Types of Prepayment Penalties

There are two common types of prepayment penalties you may face:

• tough punishment: Prepayment penalties that apply to both the refinance and the sale of the property.
• soft punishment: Prepayment penalties that are applicable only on refinancing your property.

How to avoid prepayment penalty

Fortunately, avoiding the prepayment penalty isn’t too difficult. This way:

• Work with a lender that doesn’t charge prepayment penalties.
• Get a loan estimate that doesn’t include prepayment penalties.
• Negotiate the cancellation of prepayment penalty with your current lender.

You can also occasionally make additional payments without incurring prepayment penalties. Typically, these payments only appear on your lenders’ radar when you make substantial payments (ie, 20% or more of your principal).

Is it worth paying the prepayment penalty?

The answer can be yes or no and is decided on a case-by-case basis. Check with your lender to see if you have a prepayment penalty clause in your contract. Sometimes it is advisable to keep making regular payments or invest your money elsewhere till the clause expires.

Note by BigPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.