Lenders allow borrowers to pay off their mortgage loan prior to their due date, but in some cases may charge an extra fee, known as a prepayment penalty. Beginning in 2014, the rules governing prepayment penalties changed as result of the Dodd-Frank act. Mortgages originated since the passing of the new laws must meet certain requirements in order to charge a penalty for early payoffs.
Why do lenders charge a penalty for paying off a mortgage early?
Mortgage lenders generate revenue from interest on loans. When mortgage loans pay off earlier than anticipated, the lender’s revenue generally decreases. Lenders use prepayment penalties to dissuade borrowers from paying the loan in full for a certain period of time. When early payoffs occur, the prepayment penalties offset the revenue that lenders lose in interest.
Generally, a prepayment penalty takes effect only when a borrower pays off a large amount of the mortgage in a single year. Lenders may limit the annual payoff amount to 20% of the loan. Some lenders may only charge a fee when the full balance pays off. Borrowers may typically add an extra sum each month to lower their principal balance without incurring a prepayment penalty. For example, if your monthly payment is $500 and you send $550, you might not be charged any penalty for paying off a mortgage early. It’s always best to ask your lender about a prepayment penalty prior to making an extra payment.
If your mortgage loan includes a prepayment penalty, it usually comes into play during the first three years. If you’re planning to pay off a mortgage in full, ask your lender or check your loan documents for information on any fees, including prepayment penalties, that you owe in addition to the outstanding loan balance.
What are the Rules for Prepayment Penalties on New Mortgage Loans?
Beginning in 2014, federal regulations limited the amount of prepayment penalties lenders may charge for newly-issued mortgages. Provisions in the new law included the following rules for prepayment fees:
- Prepayment fees are capped at a certain percentage.
- Prepayment penalties may not be applied after three years.
- Only certain fixed rate loans deemed “qualifying mortgages” may carry a prepayment penalty.
- The lender must also present the borrower with an alternative option that does not include a prepayment penalty. The alternative loan may carry a higher interest rate.
According to the federal rule, lenders may not charge prepayment fees on certain non-qualifying loans, such as adjustable-rate mortgages. Loans issued prior to 2014 do not fall under the new laws and may assess prepayment fees differently.
Additionally, some states also have laws capping or restricting mortgage prepayment penalties. Examples of these laws include:
New York
New York bans prepayment penalties on subprime mortgages.
Florida
Florida restricts prepayment penalties for high cost home loans.
California
California also restricts prepayment penalties on higher-priced loans. Lenders may only charge 2% of the balance for the first year and 1% in year two.
When applying for a new mortgage, take the time to read about any regulations that could apply to you.
How Do You Know if a Prepayment Penalty Applies?
Borrowers should discuss i mortgage prepayment penalties with their lender and loan documents should clearly disclose prepayment penalty details.. Either “hard” or “soft” prepayment fees may apply. A soft prepayment penalty only takes effect in certain situations, such as a refinance, but not when you resell your home. A hard prepayment fee applies in the event of any type of loan payoff.
Should you choose to pay off your mortgage early, read the fine print to ensure that you understand your prepayment responsibilities.
Why Pay off your Mortgage Early?
Considering all the fees and technicalities of paying off a loan before it’s due, you might wonder why someone would want to pay off their mortgage early. In reality, early payoffs occur for a number of reasons. When applying for mortgages, consider your personal situation and the chance that you might want to pay off the loan during the period when prepayment penalties are in effect. Borrowers may choose to incur a prepayment penalty under the following conditions:
Refinance
Many borrowers refinance a mortgage to take advantage of lower interest rates. Some of the main reasons why refinancing makes sense include the following:
- You may qualify for a better loan due to improved credit.
- Changes in the economy may drive interest rates down, making a refinance attractive to borrowers with loans at a higher rate.
- A refinance can also be used to lower the loan balance coinciding with a partial payoff of a mortgage loan.
- In a hot real estate market, home values increase. Refinancing your mortgage allows you to access additional equity for home improvements or other large purchases.
Lump sum payoff
Some borrowers may strive to become debt free and own their home outright. Annual bonus payments, extra funds from a promotion at work, or cash received through an inheritance may be used to pay off a mortgage prior to the final due date. Homebuyers who can afford to pay off the remainder of their mortgage may find the cost of the penalty worth it to avoid future interet payments.
Debt Consolidation
Payoffs may also occur when borrowers consolidate many loans to streamline monthly payments. They may also take advantage of lower rates in the process.
Relocation
A job change, marriage, or other life event may prompt a homeowner to sell their current property and downsize, upsize, or relocate. When this happens, borrowers pay off their existing mortgage using the funds from the sale of their current home before buying something new. Whether the relocation is expected or unexpected, if this happens in the first few years after a home purchase, borrowers will also need to pay off their prepayment fees.
How Can You Secure a Loan with No Prepayment Penalty?
If you wish to avoid prepayment penalties, take a look at the different types of mortgage loans available. Compare interest rates and factor in the cost of a prepayment penalty to determine which option makes the most financial sense for you. If a lender provides you with a loan that has a penalty, you can ask for other options.
Types of loans that may include prepayment penalties:
- Some fixed rate residential mortgages
- Loans used to buy investment properties
- Commercial mortgage loans
Loans typically offered with no prepayment penalty:
- VA loans
- FHA loans
- USDA loans
- Adjustable rate mortgage loans
Working with a Prepayment Penalty
Depending on a mortgage’s interest rate, loans with prepayment penalties may offer borrowers an advantageous financing opportunity if they’re in the position to pay off the remainder of their balance. If you believe the chances of an early payoff are low, agreeing to a prepayment penalty may help you secure a lower interest rate.
If your mortgage loan includes a prepayment penalty, it’s important to understand how to calculate the extra amount you’ll owe in the event of an early payoff. Some lenders assess prepayment penalties as a flat fee. Others will calculate the penalty based on a percentage of the loan balance.
When a prepayment penalty applies, check the timing. If you’re close to the end of the prepayment window, holding off on a payoff, when possible, may save money. If the mortgage payment requies a fee, include it in the amount needed to pay off the mortgage prior to writing your check and sending it to the bank or finance company.
Conclusion
Prepayment penalties help mortgage lenders recoup some of the future interest revenue they lose when a loan pays off before the final due date. Borrowers should weigh the cost of the penalty, their likelihood of paying off the loan early, and any other loan options available to them before moving forward and finalizing their home purchase.
