What is a Pre-Payment Penalty?

What is a Pre-Payment Penalty-Prepayment Penalties

Many homeowners and first-time homebuyers don’t completely understand what a pre-payment penalty is. Many don’t find out until it’s too late.

A pre-payment penalty or also known as a prepay in the mortgage industry is basically an agreement between the mortgage loan borrower a.k.a you, and the lender who regulates the amount the borrower is allowed to pay off and when they can pay it off. A majority of the lenders will allow a borrower to pay anywhere from 20% to 25% of the mortgage loan balance each year.

Now, you may be asking yourself, why would anyone pay more than 20% on their home loan in a years’ time? Well, they are most likely trying to pay off their entire mortgage earlier than their loan terms. There are a few different ways a borrower can pay off their mortgage. One way of paying off your mortgage loan is by selling your home or refinancing your mortgage, however, then you’re just more or less replacing your mortgage loan.

It’s important to be aware of the different kinds of pre-payment penalties. There are two types, soft pre-payment penalties and hard pre-payment penalties.

Soft VS Hard Penalties

A soft pre-payment penalty will allow the borrower to sell their home at any point and time without any penalty at all, but if they choose to refinance their mortgage into a new one then they could face a pre-payment penalty.

A hard pre-payment penalty is quite the opposite. If a borrower were to sell their home or refinance their mortgage they could be faced with a hard pre-payment penalty. These penalties were designed to protect lenders and investors who rely on the years’ worth of interest and payments to bring in a profit. When a loan is paid off faster than the mortgage term, regardless if the borrower sold their house or refinanced it. The investors and lenders get less money than the anticipated amount they first agreed upon with the borrower when they issued the mortgage loan.

How much is a Pre-Payment Penalty?

Great question, the pre-payment penalty is usually around 80% of what would have been 6 months’ worth of interest. When lenders first issue the mortgage loan, it’s with belief that a certain amount of interest will be accrued and collected, but when a borrower sells or refinances they are basically changing the contract of the mortgage loan and the lender then loses out on any potential profits. So the Pre-Payment Penalty was designed to protect the lenders from a loss of profit.

While a mortgage that includes a pre-payment penalty may have a much lower interest rate, it can still be a burden in the loan run if you, later on, choose to refinance earlier than outlined in your mortgage agreement or decide to sell. Mortgage rates can also play a role in pre-payment penalties. Most of the bigger known lenders, like Chase, Wells Fargo, or Bank of America don’t add pre-payment penalties, but many of the smaller lenders will in order for them to be able to compete with the bigger lenders. Especially when it comes to sub-prime lending. Be sure to do as much research as possible beforehand so you know exactly what you’re getting yourself into.

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Pre-Payment Guidelines

It may seem that with the more recent mortgage guidelines pre-payment penalties are outdated and a thing of the past, but they are very much still around. In order to be sure that you avoid any penalties, re-read your closing documents very carefully and ask as many questions as you can before signing any paperwork.

In today’s mortgage market, every loan has its own set of requirements that need to be met in order for a lender to not be liable for the loan in the event the borrower were to default. If a borrower were to default on a loan that a lender mishandled that lender could potentially be liable to purchase the loan back from the investors or face being sued. Lenders who add pre-payment penalties to a loan have to follow these requirements first:

  • The loan must be a fixed rate loan.
  • The loan must be considered a Qualified Mortgage and fall under all the QM guidelines.
  • The price of the loan cannot be considered excessive.
  • A Pre-Payment Penalty cannot extend past a 3 year period and cannot exceed more than 2% of the loan amount for the first 2 years.
  • The lender is required to provide the borrower with an alternative loan for the loan with a prepayment penalty and must disclose any differences in the loans.

Pre-Payment Penalty Disclosures

Be sure to ask your lender as many questions as possible and be informed of all the pre-penalty disclosures. Just like any other mortgage you are entitled to proper disclosure regarding pre-payment penalties and the lender is required to show you information regarding the penalties in common 3 places.

Where to find your pre-payment penalty disclosures

  • Listed on your monthly billing statements
  • Listed on your monthly payment coupons
  • Listed on all and any notices received pertaining to your mortgage

One of the many benefits to the FHA loan, is there are no pre-payment penalties. Be sure to shop around to different lenders and compare rate quotes, guidelines, loan programs, and make sure your discuss with your lender pre-payment penalties before signing any contract.

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Justin McHood

Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.

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