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prepayment penalty

When you take on a mortgage loan, you may be so laser-focused on reducing your debt load that you get overeager and make payments ahead of schedule. But your exuberance and diligence can actually have a negative effect. If you pay off your mortgage too quickly, you’ll contend with a prepayment penalty. Here’s the lowdown.

Defining Prepayment Penalty

Simply put, a prepayment penalty (also called “prepay”) is a part of the mortgage agreement between a lender and borrower. It stipulates that the borrower will face a fee if he or she pays down too much mortgage debt within a particular time frame. Typically a lender will let a borrower pay off up to 20% of a mortgage balance in a given year. Pay more quickly than that and you’ll face a fee. Because of the lasting impacts that a prepayment penalty may have on one’s financial situation, it is imperative for homebuyers to understand the consequences of advanced mortgage payments.

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There are two types of prepayment penalties: hard and soft. Hard prepays penalize you more extensively, whereas soft prepays allow for some cushion. In other words, a soft prepayment penalty will let you sell your house whenever you choose to without a penalty. But a soft prepayment penalty will still penalize you if you refinance the mortgage of that home. On the other hand, hard prepayment penalties apply both to selling your home and refinancing it alike. If you end up with a hard prepayment, you shouldn’t sell your home close to the time when the penalty is issued.

Even though the bulk of prepayment penalties will only last up to around three years at the most, you should leave wiggle room for a potential need to refinance or sell your home. If this happens unexpectedly and the borrower is unprepared, the prepayment penalty for the decision can be long-lasting.

How Much Will a Prepayment Penalty Cost?

Much like the cost of a mortgage loan itself, an accompanying prepayment penalty cost will vary by lender. The prepayment penalty fee is often a percentage of the mortgage loan amount or is equal to a given number of interest payments you’d be paying monthly. Depending on how far in advance you’re paying off your mortgage loan, these fees can quickly become costly.

For instance, if you’re penalized with a 5% prepayment on a $400,000 mortgage loan, you could face a $20,000 set-back. You can very quickly end up losing a great deal of money if you aren’t careful to pay your loan back in a timely manner.

Why Are Prepayment Penalties Issued?

prepayment penalties

If a borrower were to make mortgage payments too early, the lender would miss out on interest payments it had anticipated over the life of the loan. In other words, the lender would forfeit potential profits. The prepayment penalties ultimately serve to protect the lender and ensure that the lender receives the loan interest it expects.

Prepayment penalties may come with a slightly less expensive interest rate. But before making payments early, you should should ensure that the prepay is going to save you money down the line. You certainly don’t want it to cost you more than you would have saved going the traditional route.

How to Avoid a Prepayment Penalty

The good news is that today, prepayment penalties are much rarer than they were a decade ago. They do still exist as part of a select handful of mortgage loans. But the vast majority of such loans come with the expectation that borrowers will make payments on a normal schedule. Even so, you should know precisely what you’re agreeing to when you sign any loan document.

If you realize that a prepayment loan is indeed part of your mortgage agreement, you are able to exercise your right of rescission. But you must do so within three business days of signing. Furthermore, FHA loans do not include prepayment penalties. That’s just one of several reasons why such loans may be preferable to conventional loans, which may have penalties involved.

The Takeaway

prepayment penalties

Prepayment penalties exist to ensure that lenders get the principal and interest payments they expect on mortgages. The prices can be incredibly steep, even more expensive than the original interest of the loan. Prepayment penalties are rarer than they used to be. But they are still a key complication to look out for and avoid if you are looking to get rid of your mortgage as quickly as possible. Remember, faster does not always equal better. When a prepayment penalties is involved, faster certainly does not always equal cheaper.

Tips for Buying a Home

  • Good credit brings great results, especially when it comes to homeownership. If you maintain a high credit score, you could be eligible for better mortgage rates, which can result in lower monthly mortgage payments.
  • Buying a home doesn’t have to mean sacrificing your other financial goals! If you’re unsure whether homeownership is right for your current situation, consult with a financial advisor. A matching tool like SmartAsset’s SmartAdvisor is a great way to find the perfect advisor. Answer a few questions about your finances, and the program will select up to three fiduciaries—out of a pool of thousands—who directly match your needs. This cuts your heavy lifting in half—for free.

 

Photo Credits: ©iStock.com/Jirapong Manustrong, ©iStock.com/PeopleImages, ©iStock.com/m_imagesphotography

 

Jane Thier Jane Thier writes on a variety of personal finance topics for SmartAsset. Her expertise includes banking and mortgage. Jane is currently studying at Washington University in St. Louis and serves as editor-in-chief of Armour Magazine. Jane aims to receive her Master's Degree in Journalism.
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