What is a prepayment penalty?

Considering selling your home, refinancing your mortgage or making a bigger-than-usual mortgage payment? Any of these actions could trigger a prepayment penalty from your mortgage lender, which could set you back thousands of dollars if you’re not careful.

Though increasingly rare and limited by law, prepayment penalties do exist, and apply mainly to the early years of your mortgage. Here’s how they work.

What is a prepayment penalty?

A prepayment penalty is a fee a lender charges to discourage a borrower from replacing their mortgage or terminating it far in advance of the scheduled term. It generally reflects a percentage of the loan principal.

The good news is that most borrowers aren’t subject to a prepayment penalty nowadays, but it’s important to confirm before you get or refinance a mortgage, list your home for sale or attempt to pay off your mortgage early.

Why do lenders charge a prepayment penalty?

Mortgage lenders and banks make more money when you pay off your loan over a longer term, such as with a 30-year mortgage. That’s because interest accrues over the life of a loan. If you pay off your loan early by selling your home, refinancing to a new loan or making extra payments toward your principal, the lender won’t earn as much. So it dings you, as a penalty for curtailing the years of interest payments they would’ve reaped.

“Lenders use prepayment penalties to incentivize people to keep the loan for more than just a year or two,” says Kate Bulger, vice president of business development for Money Management International, an Atlanta financial counseling nonprofit.

Types of prepayment penalties

Prepayment penalties come in two varieties: soft and hard. A soft prepayment penalty applies in fewer situations than a hard prepayment penalty.

Soft prepayment penalties

If your loan has a soft prepayment penalty, it applies only if you decide to refinance your loan. The penalty amount will be due at closing, so you need to have the cash on hand to pay it.

In some cases, a soft prepayment penalty also applies if you settle a substantial chunk of your mortgage — or all of it — within a calendar year. More on that below.

Hard prepayment penalties

A hard prepayment penalty occurs is one that can be triggered by several different situations. It can occur when:

• You refinance your mortgage
• You sell your home
• You pay off your mortgage balance entirely before the term ends
• You pay off a sizable portion of your mortgage

What’s a “sizable portion”?  “Making a few extra payments toward your principal or paying a little extra every month usually isn’t enough to trigger a prepayment penalty,” says Bulger. But if the sum amounts to more than 20 percent of your loan balance in any given year, the penalty could go into effect.

If your mortgage has a hard prepayment penalty, paying off your mortgage early might not be the best financial decision. You should ask your lender how much you’ll pay in penalty fees versus how much you’ll save in interest payments. A mortgage payoff calculator can help crunch the numbers to see if and when prepayment makes sense.

How a prepayment penalty works

When you are assessed a prepayment penalty, you’ll have to pay it as a lump sum to your lender. When you sell your home, it’s collected from the proceeds. When you refinance your loan, it’s part of the closing costs. If you terminate your loan early, or pay off a fifth of it in one year, it’ll be assessed as a separate fee.

“The penalty is always disclosed with your mortgage rate quote when you shop around for a loan,” says Anna DeSimone, New York City-based personal finance expert and author of the guide “Housing Finance 2020.” “Typically, you’ll see a statement such as ‘prepayment penalty fee equal to three months’ interest shall be paid in the event the mortgage is terminated within 12 months.’”

The terms and language of an agreed percentage penalty will also be found in your mortgage loan documents, says Charles Gallagher, an attorney in St. Petersburg, Fla.

Are prepayment penalties on every mortgage?

The Dodd-Frank Act established limitations for prepayment penalties, which went into effect in 2014. Today, prepayment penalties can only be charged on conventional loans — those originated and backed by private lenders. So, you won’t find them on FHA, VA and other government-insured or -guaranteed loans.

Among the conventional loans, the penalties are mainly “associated with non-conforming mortgages — loans not sold to or insured by government-sponsored enterprises such as Fannie Mae or Freddie Mac,” says DeSimone. You might also find them on non-qualified (non-QM) mortgages, which are geared towards applicants who don’t fit traditional borrower profiles and so feature looser criteria — but higher fees.

How much are prepayment penalties?

Dodd-Frank also set limits on the size and timing of prepayment penalties.  A fee can only be assessed during the first three years of the loan term. The penalty can be 2 percent of your principal balance within the loan’s first two years and 1 percent of your loan balance in year three.

For example, say you want to sell your home only one year after you took out a non-conforming mortgage loan to purchase it. Suppose your remaining balance is $300,000. At closing, you’ll likely be charged a prepayment penalty of $6,000, which amounts to 2 percent.

How is a prepayment penalty calculated?

Prepayment penalties can be charged in a variety of ways. They may be calculated as a percentage of the remaining loan amount — typically 1 to 2 percent. The penalty could be equal to a certain number of months’ interest. Or some lenders may charge a flat fee.

The prepayment penalty details will be detailed in your loan agreement.

Remember, federal law prohibits prepayment penalties above 2 percent of the loan amount. This is the highest possible amount you could pay.

Examples of a prepayment penalty

Here’s another prepayment penalty scenario. Say you bought a house 19 months ago and borrowed $200,000 via a non-conforming mortgage loan to finance it. Now, interest rates have dropped much lower, and you want to refinance to lower your monthly payments.

“In this case, because you are refinancing within the first two years of the loan, you would be charged a $4,000 penalty — equating to 2 percent of your balance,” says Bulger.

In contrast: Imagine you inherit a windfall and decide to use $30,000 of it to help pay off your $200,000 mortgage faster. “In this scenario, you would not be charged a prepayment penalty,” says Bulger. “That’s because your $30,000 accelerated payment is less than the 20 percent maximum your lender will allow annually as a prepayment amount.”

How to identify a prepayment penalty in you loan contract

Before you sign a mortgage loan contract, it’s always important to understand what you are agreeing to. That applies in particular to the prepayment penalties, whose details may be buried in the fine print.

Where to find prepayment penalty information

Federal law requires that lenders disclose all information about any prepayment penalties. If you do have a prepayment penalty, it should be listed in the loan estimate or in any disclosure documents.

You can also ask the lender if there is a prepayment penalty. If they say yes, ask them to show you where you can find  the details in the paperwork.

How to interpret a prepayment clause

The prepayment clause in your mortgage agreement walks you through how to pay off your loan early. This section of the paperwork will discuss exactly what you need to do to pay off your mortgage ahead of schedule. It will also outline when you might incur a prepayment penalty, and how much it will be.

Think ahead in your three to five-year plan. Is there a possibility you could refinance or sell your home within that time, or pay down a lot of the loan? Even if you don’t plan to pay off your mortgage early, understand the costs if you do. Make sure you won’t be stuck in a loan it will be costly to get out of.

How to avoid a prepayment penalty

If you don’t want to pay a prepayment penalty on your mortgage, consider these tips to avoid the expense:

• Shop the market: Shop around with different lenders, and pass on loans that impose the fee.  Under Dodd-Frank, lenders that do charge a prepayment fee are required to also offer a mortgage option without one, according to Experian.
• Call your mortgage lender/servicer: Ask if a prepayment penalty applies to your current mortgage.
• Negotiate: If a prepayment penalty is attached to your mortgage, ask to have it removed, or try to negotiate a lower one.
• Time a home sale, refinance or accelerated payment strategy carefully: See if you can wait until you’re beyond first three years, after which penalties can no longer be imposed.

Mortgage prepayment penalty FAQ

• Which types of mortgages have prepayment penalties?

  Prepayment penalties are less common than they were a decade ago. The Dodd-Frank Act prohibits most prepayment penalties for current residential home loans, but they’re still allowed for mortgages that were executed before Jan. 10, 2014. They apply mainly to non-QM loans and conventional, non-conforming loans. FDA, VA and USDA loans do not have them.

• Does prepaying a mortgage loan impact my credit score?

  Prepaying your mortgage may cause your credit score to drop slightly, but only temporarily. Retiring the debt may reduce your overall credit mix, which includes the various types of credit accounts you have in your name. It may also shorten your credit history — that is, the average age of your accounts. Both are important factors that contribute to your overall credit score.

• How do I find out if my mortgage has a prepayment penalty?

  You can contact your lender to find out whether your mortgage has a prepayment penalty. Lenders are legally required to disclose such information.

• Should I pay off my mortgage early?

  If you’re considering paying off your mortgage early, it’s important to run the numbers and understand the costs. If you’re paying off the mortgage within the first three years and will face a prepayment penalty, it may be best to hold off a little longer. However, if you’re more than three years into your mortgage and  have the financial means to do so, it can be a beneficial step, saving you decades of interest payments.

Additional reporting by Emma Woodward