When you take out a mortgage, you may run into tons of fees. Origination fees… Appraisal fees… Rate lock fees… Late fees… The list of fees goes on and on.
But did you know that there are also fees for paying off a mortgage early? That’s right! They’re called prepayment penalties, and they can pop up at unexpected times, like when you refinance your home.
Here’s what you should know.
What is a prepayment penalty?
A mortgage prepayment penalty is a fee that lenders may charge if you pay off some or all of your mortgage early. This includes when you refinance your home, as you have to pay off your original loan before taking on another.
Note that prepayment penalties don’t usually apply to making a few extra payments a year. In fact, most lenders let you pay off up to one-fifth of your loan balance each year, penalty-free. But you may run into early payment penalties when you refinance, sell, or make an especially large lump sum payment.
How do prepayment penalties work?
Not many people can afford to repay their home loan in just a year or two. But plenty of people refinance their loans for credit reasons or to get a lower interest rate. Unfortunately, you may have to pay prepayment penalties in this process.
But these fees do come with limitations under the Dodd-Frank Act. For all mortgages originated after 2014, lenders may only charge prepayment penalties on conventional mortgages if any of the following situations apply:
- Repay the loan within 3 years of signing.
- Pay a fixed interest rate on a qualified mortgage.
- You don’t pay a subprime mortgage rate.
Lenders must also cap their fees at a set limit under federal law. Lenders must also offer an alternative loan that doesn’t include a penalty for paying off your mortgage early. Note that these rules don’t apply to mortgages originating pre-2014.
Why do lenders charge prepayment penalties?
All lenders agree that receiving payment on their loans is good business. But mortgages are exceptionally large loans that generate thousands of dollars in interest (read: profit) over 15-30 years. If you repay your loan early, the lender misses out on these profits.
Prepayment penalties are one way that lenders discourage homeowners from repaying their loans early. For borrowers who refinance or repay their loan anyway, the penalties help the lender recoup some of their lost profits.
Do all loans have prepayment penalties?
Not all loans come with penalties for paying off a mortgage early. In fact, lenders legally can’t charge early payment penalties on most government-backed loans, including VA, USDA, and single-family FHA loans. Adjustable-rate mortgages (ARMs) and subprime loans (high-interest mortgages) can’t come with prepayment penalties, either.
How much will I pay in fees?
Prepayment penalty schedules vary. Some lenders charge a fee equal to 6 months’ worth of interest, while others charge a flat rate. One of the most common models is for lenders to charge a percentage of the outstanding loan balance.
But the Dodd-Frank Act limits lenders’ fees here, too. In the first two years of your mortgage, the lender may charge a maximum of 2% of your loan balance. In the third year, they can’t charge more than 1%. Some lenders also set a dollar cap on your penalty so you don’t pay over a set limit regardless of the size of your mortgage.
Example of prepayment penalty schedule
Let’s assume that you take out a mortgage for $200,000. Using a sliding scale percentage penalty, your fee schedule might look like this:
| Year of Loan | Prepayment Penalty | Penalty Amount Owed |
| 1 | 2% | $4,000 |
| 2 | 1.5% | $3,000 |
| 3 | 1% | $2,000 |
How to avoid prepayment penalty on mortgage
You can avoid prepayment penalties if you know what to look for or if you’re a keen negotiator. Here are some tips.
Compare loans
By law, lenders must disclose their early payment penalties before you sign on the dotted line. You can ask your lender if they charge these fees and where to find them in your loan documents.
Additionally, lenders who charge prepayment penalties on conventional loans must offer a penalty-free option, though it may come with a higher interest rate. Or you can skip the hassle and stick with lenders that don’t charge these fees at all.
Negotiate
If you’ve found your perfect lender, you may try to negotiate for a lower fee. Start by asking if they’ll waive the fee entirely without raising your rate. If they won’t, you can try to negotiate a lower fee or a fixed schedule instead of a percentage-based fee.
Learn what triggers fees
Prepayment penalties only crop up in certain situations. You may run into one of two types. Soft prepay penalties apply to refinances only. If your loan has a soft early payment penalty clause, you won’t incur the charge for selling your home or repaying your loan in full. Hard prepay penalties apply prepayment penalties in any situation, including refinances, selling your house, or paying part or all of your loan off early.
Know the law
The best way to avoid prepayment penalties is to know when they’re allowed and when they’re not. For instance, lenders can’t charge these fees on subprime mortgages or ARMs. Lenders must also cap their prepayment penalties at three years.
Additionally, some states don’t permit lenders to charge these fees. But banks may be able to get around these laws if they operate under federal instead of state statutes.
Is it worth it to pay off your mortgage early?
If you can afford to pay off your mortgage early, you stand to save thousands in interest payments. For most homeowners, their savings far outweigh any financial penalties the lender may impose. But if you think you’ll pay more in penalties than you will in interest, you may want to wait it out and repay your loan once the penalty period passes.
Don’t let prepayment penalties drag you down!
Nobody wants to pay extra fees on their mortgage, but fortunately, those fees are pretty easy to avoid. Nowadays, lenders must legally offer loans that don’t include prepayment penalties, although you may pay a higher interest rate in the process. Better yet, you can switch to a lender that doesn’t charge them at all!
FAQ
Is it beneficial to pay off your mortgage early?
For most homeowners, paying off your mortgage early can save you thousands of dollars. But you’ll want to do the math to ensure you’re not paying more in penalties than you would in interest.
Is it better to pay off the mortgage or hold onto the money?
Paying off your mortgage frees up your income and builds equity in your house. For most people, paying off their mortgage early makes more sense than waiting.
What does a prepayment penalty mean?
A prepayment penalty is a fee that some lenders charge for paying off your loan early. For new mortgages, lenders can only charge prepayment penalties during the first three years of your loan.
