What Is a Prepayment Penalty?

Many borrowers dream of paying off their mortgages early. Early payment can save thousands of dollars in interest, so it may surprise you that you incur a penalty for settling your mortgage or paying off a significant portion of the balance. 

A prepayment penalty is a condition you might have agreed to when you signed your mortgage agreement. Prepayment penalties are intended to discourage borrowers from refinancing their mortgages early in the term. They apply mainly to fixed-interest mortgages and compensate lenders for lost interest income.       

Key Takeaways

• A prepayment penalty charges borrowers for early repayment of a mortgage loan.
• Don’t get caught off guard; understand your mortgage terms and conditions.
• Avoid prepayment penalties if you plan to pay your mortgage early by shopping for loans.

What Is a Prepayment Penalty?

Mortgage lenders often include prepayment penalties in their terms and conditions. It is a clause where you agree to pay a specified amount or percentage of the balance if you settle your mortgage early or pay a significant portion before the end of the term. A prepayment penalty usually has an end date, typically applying to the first three years of the mortgage origination date but sometimes lasting up to five years. 

The penalty is often a percentage of the outstanding balance but could also be a specified flat fee or several months’ interest.  

Why Do Mortgage Lenders Charge a Prepayment Penalty?

Mortgage lenders charge a prepayment penalty to discourage borrowers from paying principal earlier than agreed, particularly to disincentivize refinancing early in the mortgage term. 

The first few years of the term are the riskiest for the lender. The borrower doesn’t have much equity in the property, so the financial risk is higher. Interest is the lender’s compensation for this risk and an income source. The prepayment penalty reimburses lenders for the loss of income. Often, buyers and lenders negotiate lower-than-average interest rates, so the penalty helps recover profit losses. 

Types of Prepayment Penalties

Here are two main types of prepayment penalties. 

Soft Prepayment Penalty

A soft penalty is less restrictive than a hard penalty and applies only to certain situations. Often, soft penalties apply to refinancing but may not apply if you sell your home. The intention is to disincentivize mortgage refinancing, which discourages you from moving to another lender and keeps the lender’s interest coming in. Your mortgage contract will contain the penalty details, including the penalty duration and amount.

Hard Prepayment Penalty

A hard penalty is a stricter prepayment penalty. It imposes a penalty for paying the principal early. Penalties apply to refinancing and the sale of the house and are typically activated for up to three years after origination. 

How to Find Out if You Have a Prepayment Penalty

You must understand what triggers the prepayment penalty on your mortgage. Use this information to make informed decisions about paying your loan early. All lenders must legally include terms and conditions on the original mortgage agreement. The prepayment fee and any time limitations appear on your contract. Prepayment penalties are only active for the first few years of the mortgage term.  

Most mortgage agreements allow a limited prepayment amount without triggering a penalty. 

Check the contract to learn the terms of your loan, or call the lender and ask them to explain the specific terms. The prepayment penalty should also appear on your monthly billing statement. 

How Much Is a Prepayment Fee?

The penalty amount varies according to the loan agreement. Most prepayment penalties apply for the first two to three years of the mortgage term. Lenders structure the prepayment penalties differently. Here are some common methods to calculate them:

• Percentage of the loan balance: This method is commonly used and usually stipulated between 1% and 3% of the loan balance. 
• Sliding percentage scale based on the loan age: A prepayment penalty might be 3% of the remaining balance in the first year, 2% in the second, and 1% in the third. 
• A flat fee: The lender sometimes charges a flat fee regardless of the outstanding amount.
• Interest for a period: This method charges a fee equivalent to a predetermined number of months’ interest as a penalty for early payment. 

Examples

Percentage of the loan balance

• Let’s assume you still owe $100,000 on your mortgage. The prepayment penalty is 2.5% of the outstanding balance.

Your penalty amount is 2.5% x $100,000 = $2,500 

Month’s interest

• Let’s assume you owe $100,000 on your mortgage. Your prepayment penalty is three months’ interest. The interest rate you pay is 5% per annum. 

To find the monthly interest $100,000 x 0.05/12 = $416.66 x 3 = $1,250 

Your penalty amount is $1,250

How to Avoid a Prepayment Penalty

Before you take out a loan, shop around to find out what is available. Not all lenders charge prepayment penalties. Compare offers and look for lenders with no prepayment penalties or those with short penalty periods.

Loans without a prepayment penalty may charge higher interest rates than those with a penalty clause. Weigh the costs and benefits to decide which loan best suits your medium to long-term plans. If you have an excellent credit score, you could also negotiate for a penalty reduction or removal. There is no guarantee of success, but it’s worth trying. If your lender agrees to waive the prepayment fee, get the agreement in writing to avoid confusion. 

If you already have a mortgage with a prepayment penalty clause, consider waiting until the designated period ends before paying off the loan. 

Some loan agreements allow a certain percentage of extra payment against the capital, usually expressed as a percentage of the outstanding balance. Take advantage of this accommodation and pay up to the maximum each year. You’ll pay your mortgage faster and save on interest. 

Another option is to refinance your mortgage with one that doesn’t have a prepayment penalty. Proceed cautiously, as this option may be worth considering only if you have negotiated a significantly lower interest rate. Ensure that interest savings cover the prepayment penalty and the closing costs of the new mortgage.  

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Understand Your Mortgage Before You Commit

A mortgage is one of the biggest financial commitments you will ever make. It usually involves a significant sum of money and will tie you to a lender for up to 30 years. You must understand your mortgage terms and conditions, including the existence of prepayment penalties, the triggers, and the duration. 

If you plan to pay off your mortgage in the first few years of the term, consider looking for a lender who will waive the penalty. You may pay a higher interest rate, but it may pay off in the long run. Know what you’re in for and weigh up the costs. It's in your best interest. 

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