When buying a home and selecting the length of your mortgage (the most common are 15 and 30-year mortgages), you’re likely thinking about how long you’ll be making payments on a house. After all, the chances that you could be in the same financial situation 15 or 30 years from now are highly unlikely.
So, what happens if your finances change for the better and you are able to pay off your mortgage early? In theory, this sounds like a wise thing to do, but in actuality you may be subject to a prepayment penalty.
What is a Prepayment Penalty?
A prepayment penalty is a penalty fee that some mortgage lenders will charge when you pay off part or all of your mortgage early. This fee is put in place to encourage borrowers like you to pay off their mortgage slowly over a longer period of time so that the lending company can collect as much interest as possible.
The other reason that lenders have prepayment penalties put in place is that the first few years of the home loan are riskier for the lender than the borrower because the borrower hasn’t yet paid off a significant amount of the value of the house. The interest acts as protection against financial loss should the borrower default or walk away from payments. If a borrower were to pay off the loan right away, the lender would lose out on all those interest payments.
It is important to note that this prepayment penalty may not apply if you pay off more of the mortgage amount than is due in a given period. The prepayment penalty most often may not apply when you refinance, sell, or otherwise pay off a large amount (more than 20 percent) of a loan.
Prepayment Penalty Cost
Since there are so many different types of mortgages out there, naturally the prepayment penalty attached to a mortgage can vary greatly. Some common prepayment penalties:
- Percentage of the remaining loan balance: In this scenario, the lender assigns a small percentage, such as 2% or 5%, of the outstanding principal as a penalty fee if the payoff is made within the first couple of years of the loan term.
- Certain number of months’ interest: In this case the borrower simply pays a total of a certain number of months interest as a lump sum. This could be 6 months’ worth of interest, one year’s interest, and so on.
- Fixed amount: This is the most straightforward type of prepayment penalty, but also one of the least common types of prepayment penalties for mortgages. With this, the lender writes a set dollar amount, such as $6,000, for paying off a loan within the first year.
- Sliding scale based on mortgage loan length: This is the most common type of prepayment penalty but a bit more difficult to calculate. For example, a borrower’s mortgage contract may list a sequential 2:1 prepayment penalty over the first two years of the loan. If the mortgage is paid off during the first year, the penalty is 2 percent of the outstanding principal balance, and if the mortgage is paid off during the second year, then the penalty is 1 percent of the outstanding principal balance.
The best way to know if you will have a prepayment penalty as a borrower is to read through your mortgage contract agreement and ask your financial lender to clearly explain how any prepayment penalties would be calculated.
Do you need help deciding which option is best for you? Let us know!
Let Camino help you. We want our members to find the best option that works for their needs. We offer many options for those looking to purchase or refinance a home. Please give us a call at 800-835-3400 to speak with one of our Member Advisors, or contact us for more information. NLMS ID 666196