How Do Prepayment Penalties Work?
Financial institutions and lenders make their money by charging interest on any capital they lend out. The longer the term of the loan, the more the lender stands to make by way of interest.
Still, certain conditions may entice the borrower to pay off their balance earlier than agreed upon and doing so would ultimately result in less interest revenue for the lender. In order to safeguard themselves from this scenario, lenders will usually institute a penalty for paying off a mortgage early.
Lenders may also institute a mortgage prepayment penalty to protect themselves from borrowers who are looking to sell or refinance a home within the first 5 years.
It is important to note that the laws regarding a mortgage prepayment penalty have changed over the last few decades. In the past, the lender had no responsibility to inform the borrower of any prepayment penalty stipulations in the lending agreement.
This has changed, and these days the lender must now inform the borrower of exactly what penalties will be incurred should they decide to pay off more than what is allowed in the agreement.
Each lender will have their own set of criteria for determining the cost of a prepayment penalty. Generally speaking, it is calculated based on the number of years remaining on the loan, the outstanding balance, and the APR the loan carries.
Many loan agreements include specific allowances for a limited prepayment amount and the borrower should make sure to have all prepayment questions clarified before accepting the loan agreement. This can be especially true for those who are looking at online mortgages where communication with a human representative may be limited.
Different Types Of Prepayment Penalties
As previously stated, the exact amount a mortgage prepayment penalty may carry varies depending upon the lender and the individual agreement. That said, prepayment penalties fall under two general categories: ‘Soft’ and ‘Hard’ prepayment penalties.
Soft Prepayment Penalty
In this case, the borrower is allowed to sell their house at any time so long as they do not choose to refinance the mortgage. Should they decide to refinance, a prepayment penalty will be applied.
Hard Prepayment Penalty
Unlike a soft prepayment scenario, the borrow will incur a penalty should they decide to sell the home or refinance their mortgage. The penalty for selling one’s home under a hard prepayment agreement can be quite severe and is best avoided whenever possible.
Special Prepayment Considerations
As mentioned above, the prepayment penalty imposed on borrowers by lenders can vary significantly on a case by case basis. A lot has to do with how much of a risk the lender perceives the borrower to be. Those with a greater prepayment risk will likely see higher penalties as a measure to discourage the borrower from refinancing their home. These types of borrowers are likelier to receive a hard prepayment condition.
Refinancing involves taking out a new mortgage to replace the existing one. A homeowner may decide to do this for a variety of reasons, but it is usually done in response to falling interest rates. Of course, the lender stands to lose money if individuals were to refinance their mortgage every time a drop in rates occurs. For this reason, a prepayment penalty is put in place to protect the bank from continual refinancing.
If you're seeking to get your mortgage loan approved it is important to make sure that all prepayment clauses are examined in detail with the lender or financial institution before agreeing to a mortgage.
Prepayment penalties for refinancing or selling one’s home usually last 1-3 years. Those who wish to pay off their mortgage in full before its maturity date normally must wait on average 5 years to avoid potentially severe penalties.
The general rule of thumb is a lender will allow an individual to pay off 20% of the loan balance every year. The typical penalty for paying off a mortgage early is 80% of six months' interest. A simple shortcut for calculating this total is taking 3% of the original mortgage amount.
Prepayment Penalty Examples
Let's say a homeowner decides to refinance their mortgage after 2 years with a remaining balance of $400,000. If the mortgage agreement stipulates a hard prepayment penalty of 5%, the homeowner would be required to pay the original lender a prepayment penalty of $20,000.
Those who are refinancing their mortgage because of lower interest rates need to determine if they will save money over the long term. In this example, the homeowner would need to save more than $20,000 in interest for the refinancing to be financially viable.
In the case of early mortgage payment, consider an individual who has taken out a mortgage of $500,000 and decides to pay off the loan in full after just one year. The homeowner would be subject to a penalty of $15,000.
Some Final Thoughts
Repaying a mortgage early can mean immense interest savings, however, prepayment penalties could thwart these plans. Be sure to check a mortgage loan agreement carefully before prepaying to ensure that the potential penalties don’t outweigh the benefits of early repayment.