Prepayment penalty explained

A prepayment penalty is commonly included in a provision in a mortgage contract that states that if the borrower pays down or pays off the mortgage early, usually within the first three years of committing to the loan, a penalty will be levied. The penalty is often calculated as a percentage of the remaining mortgage debt, or as a fixed number of months’ interest. Prepayment penalties safeguard the lender from the financial loss of interest income that would have been paid over time if the loan had not been prepaid.

Prepayment penalty process

Lenders use prepayment penalties in mortgage contracts to compensate for the risk of prepayment, particularly in bad economic times and when the incentive for a borrower to refinance a subprime mortgage is considerable. These fees are not simply applied when a borrower repays the whole loan. If the borrower pays a considerable percentage of the loan debt in a single payment, several penalty clauses apply.

When a borrower is deemed a danger to the lender, adding a prepayment penalty to a mortgage can protect against early refinancing or a house sale during the first three years after closing. When a mortgage is promoted with a lower-than-average interest rate, prepayment penalties may be imposed as a strategy to recuperate some profit.

Prepayment penalties must be disclosed by mortgage lenders at the time of closing on a new loan. Such penalties cannot be applied without the approval or knowledge of the borrower.

Borrowers should, however, be made aware of any potential prepayment penalties well before the loan is closed. Borrowers should inquire about one if the lender hasn’t mentioned it.

Types of prepayment penalties

Hard Prepayment Penalties
The term “hard” prepayment penalty refers to a prepayment penalty that applies to both the selling and refinancing of a house.

Soft Prepayment Penalties
A “soft” prepayment penalty refers to one that only applies to refinancing.

Importance of a prepayment penalty

Prepayment penalties differ depending on the lender. This implies that before closing, borrowers should make sure they have a copy of the prepayment disclosure paperwork and read it thoroughly.

Prepayment penalties are calculated as a percentage of the remaining mortgage debt or as a fixed sum. They might also be graded on a sliding scale depending on how long the mortgage has been in existence.

When a refinancing or sale of a property occurs during the first two to three years of the initial mortgage, some lenders charge a penalty. Others levy a fee if the debt is repaid within the first five years.