What is a prepayment penalty?
A prepayment the penalty is usually specified in a clause in a mortgage contract stating that a penalty will be imposed if the borrower significantly repays or repays the mortgage early, usually within the first three years of the loan being committed. The penalty is sometimes based on a percentage of the remaining sum mortgage balance, or it could be a number of months of interest. Prepayment penalties protect the lender against the financial loss of interest income that would otherwise have been paid over time.
Key points to remember
- A prepayment penalty clause states that a penalty will be imposed if the borrower repays or significantly repays the mortgage, usually within the first five years of the loan.
- Prepayment penalties serve as protection for lenders against loss of interest income.
- Mortgage lenders are required to disclose prepayment penalties when closing a new mortgage.
How a prepayment penalty works
Prepayment penalties are written into mortgage contracts by lenders to compensate for prepayment risk, especially in difficult economic climates and in circumstances where the incentive for a borrower to refinance a subprime mortgage loan is high. These penalties are not triggered only when a borrower repays the entire loan. Some penalty provisions come into effect if the borrower pays off a large portion of the loan balance in one lump sum.
Adding a prepayment penalty to a mortgage can protect against an early refinance or home sale in the first three years after a mortgage closes when a borrower is considered a risk to the lender. Alternatively, prepayment penalties can be added to recoup some of the profits when a mortgage is advertised with a below average interest rate.
Mortgage lenders are required to disclose prepayment penalties when closing a new mortgage. Such sanctions cannot be imposed without the consent or knowledge of the borrower. However, borrowers should be made aware of any potential prepayment penalties well in advance of closing. If the lender hasn’t said anything about it, borrowers should ask early on.
Making small, additional principal payments over the life of the loan normally doesn’t result in penalties, but it can’t hurt to ask your lender to make sure.
Types of early repayment penalties
A prepayment penalty that applies to both the sale of a home and a refinance transaction is called a “hard” prepayment penalty. A prepayment penalty that applies only to refinancing is referred to as “soft”.
Early repayment penalty limits
Although some home loans include prepayment penalties, they are not legal on FHA single family loans. For other home loans, lenders can only impose prepayment penalties for the first three years, with limits on the amount of the penalty. Additionally, lenders should offer a loan that does not include a prepayment penalty as an alternative.These rules are in effect for loans issued after January 10, 2014, established by the Consumer Financial Protection Bureau (CFPB) following the adoption of the Dodd-Frank Act of 2010.??
VA mortgages granted to military and students do not allow prepayment penalties.
Prepayment penalties vary among lenders. This means borrowers must be diligent in requesting – and fully understanding – the Prepayment Disclosure Document before closing. Prepayment penalties can be set either as a fixed amount or as a percentage of the remaining mortgage balance. They can also be valued on a sliding scale depending on the term of the mortgage.
Some lenders impose a penalty when refinancing or house sale is completed within the first two to three years of the original mortgage. Others charge a fee when the balance is paid off within the first five years.
Example of early repayment penalty
Homeowner decides to refinance two-year mortgage with a remaining balance of $ 250,000. If there is a 4% prepayment penalty, said homeowner would pay $ 10,000 to the original lender for prepaying the mortgage. Borrowers should know the details of prepayment penalties from their lender; they can dramatically increase the cost of refinancing a mortgage or selling a home.