How Do Mortgage Prepayment Penalties Work?

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Prepayment penalties are a part of many mortgage contracts that make it expensive to refinance into a new home loan. If your mortgage contract includes a prepayment penalty, you may have to pay your original lender thousands in additional fees as part of any future refinance.

Definition of a Mortgage Prepayment Penalty

Prepayment penalties can be found in almost every type of loan, but they're especially relevant to mortgages because home sales and refinances are so common. Even though most mortgages in the US come with 30-year terms, few borrowers end up sticking with the same home loan for that long. As time goes by, people find reasons to move houses, refinance for lower rates or simply make bigger payments to reduce their interest costs.

In each case, mortgage lenders stand to lose a substantial amount in future interest if a borrower repays the full principal ahead of schedule. They're used to protect themselves from the loss of interest over the loan term, and guarantee some measure of profit, even when borrowers pay them off ahead of schedule. Although specific rules differ for each mortgage lender, prepayment penalties can be triggered by any variation of the following:

Situations Involving Mortgage Prepayment Penalties

  • Selling your home before the end of your mortgage term
  • Refinancing your mortgage within the first five years
  • Repaying more than 20% of your total mortgage balance in one year

Calculating a Prepayment Penalty on a Mortgage

How much a mortgage prepayment penalty costs will depend on your remaining balance, mortgage rate and the rules set by your lender.

Types of Mortgage Prepayment Penalty

  • Fixed flat fee
  • Percentage of owed interest
  • Percentage of remaining balance
  • Sliding scale

Some mortgage lenders charge prepayment penalties as 80% of six months' worth of interest on your final loan balance, while others calculate a flat 2% to 5% of the balance itself. These numbers may also change over the life of your home loan: the longer you stay in the mortgage, the lower your prepayment penalty goes. In rare instances, a mortgage lender may set the prepayment penalty as a flat fee.

As an example, consider a 30-year fixed rate mortgage at 4%, with about $170,000 left in the principal after three years of monthly payments. If the prepayment penalty that demands 80% of 6 months in interest, you would need to calculate the following:

  • Determine your interest-only payment for current month = $551
  • Multiply one month of interest by 6 = $3,303
  • Multiply 6 months' worth of current interest by penalty ratio of 80% = $2,645

Note that in most cases, the penalty calculation doesn't account for any decrease in the mortgage balance. This means that the penalty is actually equal to 6 times the interest you would pay in your final month —which is more than the actual interest you'd owe over the next 6 months. If you're trying to refinance at a lower rate but have a prepayment penalty in your old loan, you'll need to add it to the closing costs of the refinance when you consider the tradeoff between more fees and reduced interest.

How to Avoid Prepayment Penalties When You Refinance

When it comes to avoiding prepayment penalties, prevention is the best cure. Because so many aspects of the mortgage process is negotiable, it's quite possible that you can convince a lender to reduce or eliminate the prepayment penalty. For instance, you could ask for a penalty term of five years to cover just the first three years of your loan —after which you would be free to sell or refinance.

Another option to avoid prepayment penalties on a new mortgage would be to opt for an FHA loan. Since 2014, the Federal Housing Administration's rules have prevented mortgage lenders from charging FHA borrowers with interest payments after they fully repay their loans. This adds to the many benefits of choosing an FHA loan for your first home purchase: not only will you have lower requirements for down payment and credit score, you'll also be able to refinance out of the FHA mortgage without any penalty attached.

If you're trying to refinance your way out of a mortgage that has a prepayment penalty, you might be able to refinance with a new lender who's willing to foot the bill. In other cases, you may find that your old lender makes a distinction between early repayments that occur because of a sale, as opposed to a refinance. You're far better off asking about the specifics of prepayment sooner rather than later. If you're already partway through the loan, you may find that the only thing you can do to avoid prepayment penalties on a conventional home loan is to wait out the typical 5-year period.

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