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What is a Prepayment Penalty?
You’re a few years into your mortgage and have decided to pay it off early. Due to a term in your loan agreement, you know that you will have to pay your lender a fee in order to do so, or a prepayment penalty.
A prepayment penalty is an agreement that regulates how much a borrower is allowed to pay off and when. If you pay off your mortgage early, you will be subject to a fee. While this concept may seem unfair, remember that it protects lenders and investors that rely on interest to make money.
Soft vs. Hard Prepayment Penalties
There are two types of prepayment penalties—soft and hard. A soft prepayment penalty lets you sell your home at any time, but if you refinance you have to pay a fee. On the other hand, with a hard prepayment penalty you have to pay a fee if you sell your home or refinance it at any time within a set number of years. Fees vary, but are can get up to 80% of six months interest.
If your loan has a prepayment penalty attached to it, you should be able to choose which penalty is best for you. For example, if you’re planning on staying in your home for more than 6 years, a hard prepayment would probably be best. Talk to your loan officer to decide what’s best for you.
The Benefits of Prepayment Penalties
Believe it or not, there can be benefits to prepayment penalties. Mortgages with prepayment penalties usually have lower rates than those that don’t. They can also reduce what you pay out-of-pocket on the loan.
If you don’t want to pay a penalty should you decide to pay off your loan or sell early, find a loan that doesn’t come with one. Most mortgages today don’t come with a prepayment penalty, but it will vary from lender to lender. Loans that do not allow prepayment penalties are:
Remember to read over your loan agreement for prepayment penalties before you sign it. If you find out that you’re subject to a prepayment penalty that wasn’t disclosed, you could exercise your right of rescission.