What is a mortgage prepayment penalty?
Mortgages are a long-term investment and a lot of planning goes into the decision to get one. There are many different factors to consider such as cost and loan type. Some loan types come with unexpected costs. A mortgage prepayment penalty is what it sounds like, a penalty for paying off your mortgage early. A prepayment penalty is something that can make a big difference in your mortgage loan but is often misunderstood or forgotten about all together. Understanding it can make buying a home so much easier and can deeply impact your finances. First, you need to understand what a mortgage prepayment is and then you can understand what a prepayment penalty is and how it affects you. Once you grasp these two things you’ll be able to make a more informed decision when selecting a mortgage loan.
What is a mortgage prepayment?
A mortgage prepayment is when you pay off your mortgage early on, either via a partial or full curtailment.
- Partial curtailment is when you pay a large portion of your mortgage loan off before your payoff date. This type of payment decreases the amount you owe on your mortgage.
- Full curtailment is when you pay off your mortgage completely within the first 12, 24 or 36 months of getting the loan.
By paying significantly more on the principal amount than the agreed-upon monthly payments, or by paying it off completely, you’re ensuring you pay off your mortgage before the set date. This can come with some up-sides or some less-than-great consequences, like a prepayment penalty. It’s important to note that paying a little extra on your monthly payments will not trigger the penalty. Only larger payments such as partial and full curtailment trigger the penalty.
What are the benefits of mortgage prepayment?
There are many advantages to prepayment that make it very appealing to homeowners. Before learning how to pay off your mortgage early, you should be aware of the benefits.
Some benefits you can expect are:
- You pay less in interest.
- You gain equity in your home faster, allowing you to own your home sooner than later.
- You have extra money in the long run to invest in other expenses (home repairs, tuition, retirement, etc).
This is probably the most appealing aspect of mortgage prepayment. With every mortgage comes an interest rate. The average mortgage spans 30 years and in that time, your lender collects interest on the principal loan amount. How much interest is collected is based on the agreed upon interest rate when you first selected your mortgage loan. Thirty years of interest payments can add up to a significant chunk of change. Through prepayment, you’re able to bypass some of that interest collection. Since you’re paying off your loan in a shorter time span, less interest is accrued and your total, overall payment is less than if you had taken the full 30 years to pay off your mortgage. In cases of a partial curtailment, some lenders may recast your loan, resulting in financial savings. This means they recalculate your monthly payments based on your outstanding balance.
If the lender recasts the loan and your monthly payments lower, the money you save through prepayment can be allotted to other things such as investments, tuition, retirement, home expenses and repairs, among other things. Families with other high-priority expenses can benefit financially from this form of prepayment.
Equity, in regards to a mortgage, is how much ownership you have over the property. When you purchase a property, you have the total cost of the home, your down payment and your mortgage amount.
A down payment is how much of the total home cost you can afford to pay up front. The mortgage amount is determined by the remaining cost of the property after your down payment. The larger your down payment, the more equity you have in the home. However, if you can only afford to make a small down payment, this increases your loan amount.
Most lenders require private mortgage insurance (PMI) for homeowners who make a smaller down payment. When you pay more than your monthly mortgage payment, that amount goes toward paying off the total loan amount. Not only does this decrease accrued interest, but it increases your equity. Once a homeowner has 20% equity, it’s much harder to walk away from the property. This makes the investment much more secure for the lender and improves the chance that they will be repaid. When this happens, homeowners like you can typically cancel your PMI which saves you money and energy.
What are the downsides to paying off your mortgage early?
While prepayment sounds amazing, it can come with downsides. Some downsides to paying off your mortgage early are:
- You could be charged a prepayment penalty.
- You could no longer claim the mortgage interest tax deduction.
- You’ll have less money for immediate emergencies.
Some mortgage lenders have a mortgage prepayment penalty, which can make paying off your home early a very unexpected headache. Let’s talk about it.
What is a mortgage prepayment penalty?
If you haven’t heard of a mortgage prepayment penalty before, you’re not alone. Most people haven’t heard of it. It can make a significant difference in your finances though, so it’s important to understand what it is.
Mortgage Prepayment Penalty Definition
A prepayment penalty is a penalty for paying off a mortgage early. It’s usually specified in your loan estimate, but can also be found in a prepayment clause or closing disclosure. It is so important to understand your loan agreement before signing it. The penalty can be charged if you pay off the full amount early, and in some cases, if you prepay a partial amount. Lenders penalize borrowers for prepayment because it impacts how much interest they can collect from you. For them, they charge a fee to make up the lost revenue that would have been made on the loan.
There are a couple of different prepayment penalties:
- A soft prepayment penalty occurs when you refinance your loan.
- A hard prepayment penalty occurs when you sell your home or refinance your loan.
Are mortgage prepayment penalties legal?
While prepayment penalties are prohibited for many types of home loans, mortgage prepayment penalties are legal under certain circumstances. Penalties must be in the prepayment clause, however. You cannot legally be charged a penalty if it wasn’t in the mortgage loan agreement you signed or if the agreement was misleading. There are also financial and time restrictions on penalties. Every mortgage prepayment penalty can only be charged within the first three years of the loan. After that, it is no longer legal. There is a financial cap on the amount that can be charged as well which can be found in the Dodd-Frank Act.
What are the expected costs of a prepayment penalty?
Every mortgage loan is different and all lenders have differing penalty practices. However, they do follow certain rules noted in the Dodd-Frank Act. The cost of a penalty depends on a few variables:
- What is your current loan balance?
- How many years have you had the loan?
- Does your lender charge a penalty for partial prepayment, full prepayment or both?
It’s not uncommon for lenders to charge a certain number of months’ interest as a penalty. They can also charge a set rate previously determined in the loan agreement.
Does Guaranteed Rate have prepayment penalties?
Guaranteed Rate (GR) does not have prepayment penalties. We want our borrowers to have the best mortgage experience possible. If you are worried about being penalized for paying off your mortgage early, you don’t have to stress about that when you work with us.
Should you select a mortgage with a prepayment clause?
This question is subjective and depends on your situation. There are many factors you should personally consider before signing onto a mortgage with a prepayment clause.
Selling and refinancing
How long do you plan to live in your home? The amount of time you’ll be in one place can determine if you’ll incur the penalty. If you know you won’t be there very long, you may not want to select this type of mortgage. Similarly, if you plan on refinancing your home, the penalty could affect you.
Consider the costs
The reason many people fear prepayment penalties is because they didn’t plan ahead. If you weren’t expecting additional costs, they’re going to come as an unpleasant shock and can even put your finances in trouble. If you can estimate how long you’ll be in a home, you can usually calculate how much of a penalty you’ll incur. Lenders must clearly state the terms of the penalty in the clause, so it shouldn’t take much guesswork to figure out potential expenses. You should ask yourself:
- How much will it cost you to live in the home past three years (the maximum time a lender can charge a penalty)?
- How much will it cost to pay off your mortgage early in addition to the prepayment penalty?
- Is it important to you to have the option to make early payments?
A responsible home buyer will weigh their options before making a firm decision.
Work with the lender
A good lender understands that selecting a mortgage is a big decision. They also understand borrowers’ hesitation to select one with a mortgage prepayment penalty. Often, they’re willing to work with you to negotiate the fee. You can sometimes lower the penalty fee, but it’s unlikely they will ever waive the fee completely. Accepting a prepayment penalty in the terms of your loan agreement can in turn result in a lower interest rate. Lowering or waiving the fee can increase the interest rate, which is something to consider. Any changes to the prepayment penalty clause need to be solidified in writing.
Not right for you? How to avoid a prepayment clause
The best way to avoid prepayment penalties is by working with a lender that doesn’t charge one at all. While you can negotiate the costs with a lender that does have the penalty, it’s unlikely for them to waive the fee altogether. You can also consider changing your loan type, but if you’re happy with the type you are considering, look for the same loan terms from different lenders that don’t have penalties.
Guaranteed Rate does not have mortgage prepayment penalties. If you want to avoid penalties in your mortgage loan, Guaranteed Rate is a great option. To learn what your future mortgage payments with us could cost, test out our mortgage calculator.
Powered by Froala Editor