What Is a Prepayment Penalty and How Can It Affect You?
While many people think paying off debt as soon as possible will save you money, this isn’t always the case. It’s easy to feel exhausted by your bills and growing debt, and this leads many to aggressively pay off their loans as quickly as possible. However, you might find yourself hit with a prepayment penalty.
Prepayment penalties are most commonly seen in mortgages, and it’s a fee charged by the lender if you pay off all or a portion of your loan early. This might happen because you sold your home, refinanced your mortgage, or just because you were able to quickly pay off your home loan.
You’ll only have a prepayment penalty if it’s something that was agreed to in your mortgage. More importantly, it usually only applies if you pay your mortgage off within a short period of years, usually 3-5 years. In this guide, we’ll dive deeper into what you can expect from a prepayment penalty and how it might affect your mortgage.
Why is There a Prepayment Penalty?
You’re likely wondering why a prepayment penalty exists in the first place. The lender is getting back their money in full, and they’re getting it faster. Isn’t that a good thing? In short, not exactly. The money you pay on your mortgage is stacked with interest. This is how lenders make a profit.
The prepayment penalty is a way for the lender to mitigate the loss in interest. For instance, if you pay your loan off several years early, that’s years worth of interest the lender won’t be getting. Note that this fee is only if you pay off your loan early, usually within a certain period of time. You won’t be subject to any prepayment fee for paying off your loan at its expected time.
How much will the prepayment penalty cost you? It depends. Since the 2008 loan crisis, mortgage lenders are less likely to include a prepayment penalty. However, it will depend on your particular location and lender since laws vary by state. The actual cost of the penalty will also depend on what you agreed to when you closed on your home. It will either be a percentage of the principal balance or a single lump sum.
How to Avoid Prepayment Penalties?
You don’t have to be caught off guard with a prepayment penalty. Your first line of defense is to carefully read your loan and closing estimate. Any prepayment penalty should be outlined within the disclosures, usually hidden in an area called “Addendum to the Note.” You can always talk to your lender to try to negotiate this fee away before signing.
If you’re unable to negotiate the fee, ask your lender for an additional quote with a similar loan without the fee. It’s always smart to compare both loans with and without prepayment penalties. You might find a better option, or you might choose to shop around for a different lender.
If you choose to proceed with a loan that has a prepayment penalty or your existing loan already has a penalty, make sure you know what you’re getting into. What exactly are the circumstances under which you have to pay? Is the penalty for only partial payments or full payments? Finally, does it apply if the home is sold or refinanced?
Understanding the full terms of your loan isn’t always easy, but it is necessary. Don’t let the prepayment fee keep you from paying off your loan early if that’s your financial goal. Lowering your debt is always a good idea, but make sure you read the fine print on your loan to avoid unexpected fees.