Prepayment Penalties in Mortgages

By Eric Tyson, Robert S. Griswold

Some lenders punish borrowers severely for repaying all or part of their conventional loan’s remaining principal balance before its due date. As punishment, they impose a charge known as a prepayment penalty. Prepayment penalties aren’t permitted on FHA, VA, USDA, and FmHA mortgages.

How much money are we talking about? That depends. Maximum permissible prepayment penalties vary widely from state to state, from one lender to the next — and even from one loan to the next on mortgages offered by the same lending institution. Some lenders will waive the prepayment penalty if you get a new loan from them when you refinance your mortgage or if you’re forced to pay off the loan because you sell your house.

Less sympathetic souls force you to pay upward of 3 percent on your unpaid loan balance, which equals $3,000 on every $100,000 you prepay. Even less humane lenders may insist on a penalty equal to six month’s interest on your outstanding loan balance. If, for example, your mortgage’s interest rate is 8 percent per annum, you’d have to pay $4,000 per $100,000 of principal you repay early.

Now that we have your attention, here’s how to determine whether the lender can impose a prepayment penalty:

  • Ask: Now that you know what to ask, don’t be shy. Look your loan officer right in the eye and specifically inquire whether the loan you’re considering has a prepayment penalty. If it does, strongly consider your search until you find another equally wonderful mortgage without a prepayment penalty. Some lenders will be willing to negotiate and reduce or even eliminate the prepayment penalty — all you have to do is ask!
  • Read: Even if the lender says the loan doesn’t have a prepayment penalty, don’t take chances. Verify that the mortgage doesn’t have a prepayment penalty clause by carefully reading the federal truth-in-lending disclosure you’ll receive from the lender soon after submitting your loan application. Even good lenders frequently don’t know the nuances of every single loan they offer.
  • Read again: Check, double-check, and check again. You must scrutinize one last document to be sure that your loan doesn’t have a prepayment penalty — the promissory note. Read it with care. Make sure a prepayment penalty clause doesn’t somehow manage to mysteriously creep into your mortgage before you sign the final loan documents.

Some mortgages have soft prepayment penalties, which may be waived at the lender’s discretion if you sell an owner-occupied one- to four-unit property after you’ve owned the property at least one year. Soft prepayment penalties are infinitely preferable to hard prepayment penalties, which are always enforced without exception.

You may be tempted to get a loan with a prepayment penalty, because you’re absolutely certain that there’s no way you’ll ever pay it off early. Circumstances have a way of changing when you least expect them to. Utterly unforeseen life changes force folks to sell property whether they want to or not. Divorce happens. People find their employer has transferred them to another state or worse — fired them! Folks pass away prematurely. Life happens.

You may decide, in your infinite wisdom, to get a mortgage that has a prepayment penalty. Fine. If your mom couldn’t make you eat your vegetables, why should you follow this sage advice? At least make sure that you completely understand the terms and conditions of your mortgage contract’s prepayment penalty clause regarding the following:

  • The amount you can prepay without penalty: For instance, some lenders permit you to prepay up to 20 percent of your original loan amount or current loan balance without penalty each calendar year. Others impose a penalty from the very first dollar of any prepayment. The more you can prepay without penalty, the better.
  • When you can prepay without penalty: You may be allowed to prepay a specific amount of money or percentage of your original loan balance quarterly without penalty. Other lenders let you prepay funds without penalty only once a year. The faster you can prepay without penalty, the better.
  • The duration of prepayment penalty: Mortgages on owner-occupied residential property often specify that the prepayment penalty expires three to five years after loan origination. Other home mortgages have prepayment penalties over the full term of the loan. The faster the prepayment penalty vanishes, the better.
  • The severity of prepayment penalty: Some prepayment penalties diminish in severity as the mortgage matures. You could, for example, be penalized 5 percent on any funds prepaid within one year of loan origination, 4 percent in the second year, 3 percent for the third year, and so on. Other mortgages impose the same vicious penalty as long as the prepayment clause is in effect. Declining penalties are better.