What Is a Prepayment Penalty?
A prepayment penalty is usually specified in a clause in a mortgage contract stating that a penalty will be assessed if the borrower significantly pays down or pays off the mortgage before term, usually within the first three years of committing to the loan. The penalty is sometimes based on a percentage of the remaining mortgage balance, or it can be a certain number of months’ worth of interest. Prepayment penalties protect the lender against the financial loss of interest income that would otherwise have been paid over time.
Key Takeaways
- A prepayment penalty clause states that a penalty will be assessed if the borrower significantly pays down or pays off the mortgage, usually within the first five years of the loan.
- Prepayment penalties serve as protection for lenders against losing interest income.
- Mortgage lenders are required to disclose prepayment penalties at the time of closing on a new mortgage.
How a Prepayment Penalty Works
Prepayment penalties are written into mortgage contracts by lendersto compensate for prepayment risk, particularly in difficult economic climates and under circ*mstances where the incentive for a borrower to refinance a subprime mortgage is high. These penalties don’t only kick in when a borrower pays off the entire loan. Some penalty provisions go into effect if the borrower pays a large portion of the loan balance in a single payment.
Adding a prepayment penalty to a mortgage can safeguard against early refinancing or a home sale within the first three years after closing on a mortgage when a borrower is considered a risk to the lender. Alternatively, prepayment penalties might be added as a way to recoup some profit when a mortgage is advertised with a lower-than-average interest rate.
Mortgage lenders are required to disclose prepayment penalties at the time of closing on a new mortgage. Such penalties can’t be imposed without a borrower’s consent or knowledge. However, borrowers should be made aware of any potential for prepayment penalties well before closing. If the lender hasn’t said anything about one, borrowers should ask early on.
Making small, additional principal payments over the life of the loan does not normally trigger penalties, but it can’t hurt to ask your lender to make sure.
Types of Prepayment Penalties
A prepayment penalty that applies to both the sale of a home and a refinancing transaction is called a “hard” prepayment penalty. A prepayment penalty that applies to refinancing only is referred to as a “soft” one.
Limitations of Prepayment Penalties
While some home loans include prepayment penalties, they are not legal on single-family FHA loans. For other home loans, lenders can only inflict prepayment penalties during the first three years, with limits on the size of the penalty. Additionally, the lenders have to offer a loan that does not include a prepayment penalty as an alternative. These rules are in effect for loans issued after January 10, 2014, established by the Consumer Financial Protection Bureau (CFPB) following the passage of the 2010 Dodd-Frank Act.
VA mortgage loans issued to military and student loans do not allow prepayment penalties.
Special Considerations
Prepayment penalties vary among lenders. This means borrowers should be diligent about asking for—and fully understanding—the prepayment disclosure document prior to closing. Prepayment penalties can be set either as a fixed amount or as a percentage of the remaining mortgage balance. They may also be assessed on a sliding scale based on the length of time the mortgage has been in place.
Some lenders impose a penalty when a refinance or sale of the home is completed within the first two to three years of the original mortgage. Others charge a fee when the balance is paid off within the first five years.
Example of a Prepayment Penalty
A homeowner decides to refinance a two-year-old mortgage with a remaining balance of $250,000. If there is a prepayment penalty of 4%, said homeowner would pay $10,000 to the original lender for paying off the mortgage early. Borrowers should be aware of the specifics of their lender’s prepayment penalties; they can substantially increase the cost of refinancing a mortgage or selling a home.
FAQs
A prepayment penalty is usually specified in a clause in a mortgage contract stating that a penalty will be assessed if the borrower significantly pays down or pays off the mortgage before term, usually within the first three years of committing to the loan.
What is an example of a prepayment penalty? ›
Let's look at a couple of examples using a loan of $250,000 and an interest rate of 5%. To illustrate another type of prepayment penalty, a sliding scale fee based on the years remaining on your loan would be 2% of $250,000 if you paid off your mortgage in year one or two. That fee would come out to $5,000.
Which one of the following examples describes a prepayment penalty? ›
A "prepayment penalty" is a charge the lender imposes on the borrower if the borrower pays all or part of the loan principal before its due date. For example, if you pay off your loan, refinance, or sell your home before a certain date, you might have to pay a prepayment penalty.
What is a prepayment disclosure? ›
This notice is to advise you of requirements that must be followed to accomplish a prepayment of your mortgage, and to advise you of requirements you must fulfill upon prepayment to prevent accrual of any interest after the date of prepayment.
What is prepayment penalty in mortgage regulation? ›
Since Dodd-Frank became law, mortgage prepayment penalties can only be charged during the first three years of repayment. The penalty amount is capped at a certain percentage of your loan balance: First year: 2% Second year: 2%
Under what circ*mstances would a prepayment penalty be charged? ›
Typically, a prepayment penalty only applies if you pay off the entire mortgage balance – for example, because you sold your home or are refinancing your mortgage – within a specific number of years (usually three or five years).
On which two documents would a pre-payment penalty be disclosed? ›
They're required by law to disclose these terms to borrowers. Ask your lender to point out the fine print in the contract that covers prepayment penalties. It should also be prominently featured in your Loan Estimate and Closing Disclosure.
How do I know if there is a prepayment penalty? ›
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.
What are prepayment penalties under Hoepa? ›
HOEPA Rules Regulating Prepayment Penalties
HOEPA prohibits prepayment penalties for high-cost mortgages. Added prepayment penalty coverage test: More than 36 months after consumption or account opening. In an amount more than 2 percent of the amount prepaid.
What is the prepayment penalty clause? ›
What Is a Prepayment Penalty? A prepayment penalty is usually specified in a clause in a mortgage contract stating that a penalty will be assessed if the borrower significantly pays down or pays off the mortgage before term, usually within the first three years of committing to the loan.
Put simply, any time you pay a bill, operating expense, or non-operating expense before it's due, you're looking at a prepayment. There are a vast range of debts and obligations that businesses may choose to settle in advance, such as wages, rent, or revolving lines of credit.
What is the 5 4 3 2 1 prepayment penalty? ›
A 5-4-3-2-1 prepayment penalty, otherwise known as a 5 year stepdown prepayment penalty, charges a 5% fee on the outstanding principal loan balance if the loan is paid off in year 1, a 4% fee in year 2, a 3% fee in year 3, a 2% fee in year 4, and a 1% fee in year 5.
Which of the following documents is most likely to disclose the amount of a prepayment penalty? ›
Which of the following documents is most likely to disclose the amount of a prepayment penalty? Whether a mortgage loan has a prepayment penalty, and its amount, is disclosed on both the Loan Estimate and the Closing Disclosure.
What is the difference between defeasance and prepayment penalty? ›
A prepayment penalty is a fee that is charged to a borrower who pays off their loan early, whereas a defeasance clause allows a borrower to pay off their loan without incurring any additional fees.
What loan has a prepayment penalty? ›
Many types of loans can have a prepayment penalty. However, prepayment penalties are more common on conventional mortgages and auto loans. Most major personal loan lenders (including all of our picks for the best personal loans) allow you to pay loans off early at no extra charge.
How to calculate prepayment penalty on a mortgage? ›
Mortgage Prepayment Penalty
- Outstanding balance of your mortgage.
- Multiply the outstanding balance of your mortgage by the annual interest rate on your mortgage.
- Divide the answer by 12 months per year to get the monthly interest payable.
- Multiply the answer by 3 (months)
- Current mortgage interest rate.
For example, a 5-4-3-2-1 step-down penalty structure for a 5 year loan term would make the borrower responsible for paying a penalty of 5% of the outstanding balance if prepaying the loan in the first year, 4% in the second year, 3% in the third year, and so on.
How do I know if my mortgage has a prepayment penalty? ›
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.
What is the 5-4-3-2-1 prepayment penalty? ›
A 5-4-3-2-1 prepayment penalty, otherwise known as a 5 year stepdown prepayment penalty, charges a 5% fee on the outstanding principal loan balance if the loan is paid off in year 1, a 4% fee in year 2, a 3% fee in year 3, a 2% fee in year 4, and a 1% fee in year 5.
