What is a mortgage prepayment penalty?

Quick insights

• Prepayment penalties are fees charged by some lenders if you pay off your mortgage early, either through extra payments or refinancing.
• Hard penalties apply if you pay off your mortgage or refinance early, while soft penalties apply if you refinance your loan with another lender.
• Contact your lender for clarification on how prepayment penalties are calculated and when they apply.

When managing your mortgage, it can be easy to overlook the details — especially when it comes to a prepayment penalty. This charge can catch you off guard if you’re looking to pay off your loan or refinance. Whether you plan on making extra payments, paying off the balance ahead of time, or exploring refinancing options, a prepayment penalty can affect your financial situation.

Understanding prepayment penalties

A prepayment penalty is a fee charged by mortgage providers when a borrower pays off their mortgage early. This can also happen by refinancing or selling the home. The penalty is meant to compensate the lender for lost interest income.

Prepayment penalties are regulated by state laws, and some states limit or prohibit them. Each lender has its own policies regarding prepayment penalties, and the terms would be outlined in your loan agreement.

How mortgage prepayment penalties work

There are different types of prepayment penalties that you may encounter, and it’s critical to understand how they function because they might affect your loan decisions.

Soft vs. hard penalties

• Soft prepayment penalty: This applies if you refinance the loan with another lender, but not if you sell the home. In this way, soft penalties are generally less restrictive.
• Hard prepayment penalty: This applies when you pay off the loan early for any reason, such as refinancing with another mortgage lender or selling your property before the mortgage is paid off. Hard penalties are therefore more restrictive than soft prepayment penalties.

A penalty might apply only if you prepay your mortgage within a certain time frame. Prepayment penalties can be common in certain types of loans, such as adjustable-rate mortgages (ARMs).

Calculating the mortgage prepayment penalty

Prepayment penalties can be calculated in several ways:

• Percentage-based: A set percentage of the remaining loan balance. Example: 2% of a $200,000 loan balance = $4,000 penalty.
• Interest-based: A penalty based on the interest that would have been paid over a set period. Example: 6 months of interest payments at $1,000 = $6,000 penalty.
• Tiered penalties: Some mortgage loans have a tiered penalty structure, where the penalty changes depending on the timing of prepayment. For example, a 5-year tiered penalty might cost 5% of the loan in year one, 4% in year two and so on. Exact penalties depend on the year of prepayment.

How to avoid mortgage prepayment penalty

You can review your loan terms if you want to avoid paying one. Some lenders and mortgages do not charge prepayment penalties — certain prime and government-backed loans, for example. Otherwise, you may be able act within the limits set by the lender to avoid triggering penalties, such as adhering to specific prepayment caps.

Sometimes, you may need to factor in the cost of the penalty rather than avoid it, depending on your goals. Consult with a financial advisor or attorney to better understand the implications of prepayment penalties and how they affect your long-term financial strategy.

Finding out if your mortgage has a prepayment penalty

To determine if your mortgage has any prepayment penalties, start by reviewing the loan documents carefully. These penalties are often outlined in the “Prepayment” or “Penalty” clauses. If the terms aren’t clear:

• Contact your lender: Ask for specific details about any prepayment penalties and how they are calculated. Utilize their websites and resources to help you understand policies and potential penalties.
• Seek professional assistance: Consult experts to understand penalty clauses and avoid unnecessary costs. Home Lending Advisors may help you make an informed decision.

In summary

When paying off your mortgage early or refinancing, a prepayment penalty might apply. First, review mortgage documents, seek lender clarification and consult professionals when needed. Always ensure a full understanding of your mortgage terms before making a decision. Understanding all the terms — including any penalties that might apply — can empower you to make smarter financial choices.