- A prepayment penalty is a fee for prepaying your mortgage.
- You will likely only pay a penalty if you pay off the mortgage, refinance, or sell within a few years of taking out your original mortgage.
- Conventional mortgages may come with prepayment penalties, but you won’t pay on USDA, VA, or FHA single-family mortgages.
- If a lender offers you a mortgage with a prepayment penalty, they must present an alternative mortgage without penalty.
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What is a mortgage prepayment penalty and how does it work?
A mortgage prepayment penalty is a commission you pay the lender if you sell, refinance, or pay off your mortgage within a certain period of time after your original mortgage closes, usually three to five years.
You probably won’t have to pay a penalty if you pay extra on your mortgage each month, or if you make extra payments here and there. This will likely only be if you a) pay off the mortgage completely by making a large payment, selling, or refinancing, or b) paying off a large chunk of your mortgage all at once.
The terms of your prepayment penalty will be included in the documents you sign at closing, but your lender should notify you of the penalties well in advance of that date. If a lender offers a mortgage that includes prepayment penalties, they are also legally obligated to offer you an alternative mortgage that does not charge penalties. If you’re already in the home buying process and your lender hasn’t broached the subject yet, don’t be afraid to ask.
Some mortgages impose severe penalties and others light penalties.
With a severe sentence, you will pay a fee if you sell or refinance your home. But with a soft penalty, you will only pay if you refinance – you can sell at no additional cost. Again, the details of whether you have a hard or soft penalty should be spelled out in your closing documents.
Legally, lenders cannot charge prepayment penalties on certain types of mortgages. You will not pay a penalty on most government-backed mortgages, including VA, USDA, and FHA single-family mortgages.
You might have a prepayment penalty on a conventional mortgage, but remember that your lender is legally obligated to offer you an alternative without a prepayment penalty.
Each lender has their own methods of charging prepayment penalties. Here are some possibilities:
- Fixed costs: Maybe you would pay $ 500 regardless of when you pay off the mortgage or how much mortgage is left over when you refinance.
- A percentage of the remaining mortgage when you sell or refinance: Let’s say you still owe $ 100,000 when you refinance your home and the prepayment penalty is 4%. You would pay 4% of $ 100,000 or $ 4,000.
- The interest: For example, you might have to pay six months of interest.
Talk to your lender or view your closing documents for full details of your prepayment penalty.
If you pay off your mortgage early, such as a few years after you take out your loan, the lender is missing out on tens of thousands of dollars that you would have paid in interest over the years.
If you are refinancing, you could go through another lender. If you are selling, chances are the buyer is using another lender. Either way, your current lender would run out of money.
A prepayment penalty can discourage you from paying off your mortgage early, so the lender can keep your business. If you pay off the loan early, the lender at least compensates for this loss.
Depending on your situation, you may decide that a prepayment penalty is worth it. For example, if you pay a flat fee of $ 500 to prepay your mortgage, but save $ 10,000 in interest, you can still choose to go.
Laura Grace Tarpley is associate editor of banking and mortgage services at Personal Finance Insider, which covers mortgages, refinancing, bank accounts and bank reviews.
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