What It Is And How Keep away from It

On this article

Do you know you might be charged a prepayment penalty for trying to repay your loans early? 

Prepayment penalties are charges that some lenders cost in case you refinance or pay your mortgage off early. Not solely are they pretty widespread—they’re additionally typically misunderstood by debtors.

On this article, we’ll focus on how a mortgage prepayment penalty works, the varieties of prepayment penalties you might encounter, and keep away from paying them. 

How Prepayment Penalties Work and Why Lenders Cost Them

Your month-to-month mortgage cost consists of principal and curiosity funds. Principal funds pay down your mortgage, whereas the curiosity funds go to your lender. If you take a mortgage, your lender expects to generate profits on these curiosity funds. Lenders embrace prepayment penalties in mortgage contracts to make you assume twice earlier than prematurely refinancing or paying off your mortgage. 

Let’s say you are taking out a 30-year mounted $250,000 at 5% curiosity. In the event you don’t enhance or make further mortgage funds, on the finish of 30 years, the overall price of your mortgage is $483,165. $250,000 for the principal and $233,165 in curiosity. 

Nevertheless, in case you all of a sudden come into cash and resolve to pay your mortgage off after two full years, your lender will solely obtain $22,619.43 in complete curiosity funds. In the event you as an alternative repay half of your mortgage steadiness, that can considerably scale back how a lot curiosity you’ll owe and lower into your lender’s earnings. 

Fortunately, prepayment penalties have gotten much less widespread. Additionally, your mortgage lender is required to tell you if they’re included in your closing paperwork. In case your lender doesn’t, they will’t cost for them in case you refinance your mortgage or pay it off early. 

Are There Limits on Prepayment Penalties?

The Dodd-Frank Act imposed limits on prepayment penalties to safeguard property homeowners from sticker shock. Lenders can solely cost a mortgage prepayment penalty through the first three years of your mortgage’s time period. Probably the most they will cost is 2% of your mortgage’s steadiness through the first two years of your mortgage and 1% through the third 12 months. 

In case you are charged a mortgage prepayment penalty throughout this era, you pay a lump sum price if you promote or refinance your house. 

Additionally, federal legislation prohibits lenders from charging prepayment penalties you probably have an FHA mortgage, a USDA mortgage, or a VA mortgage. Scholar loans are additionally exempt from these charges. 

Examples of Prepayment Penalties

Let’s say you are taking a 30-year mortgage mortgage out on a property for $300,000 with a 5% mounted rate of interest. A little bit after a 12 months, your own home skyrockets to a brand new market worth of $350,000, so that you resolve to promote it despite the fact that your lender knowledgeable you of your contract’s prepayment penalty clause. 

At this level, you continue to owe $295,000. Because you’re promoting inside the first two years of possession, your lender expenses you a 2% prepayment penalty of $5,900 ($295,000 x 2%). In the event you wait till your third 12 months, the penalty drops to 1%, or $2,950. After accounting for closing charges and the true property agent’s lower, is it value taking within the residence one other 12 months or two to scale back or eradicate your prepayment penalty? That every one depends upon your circumstances.

Let’s say you resolve to refinance your mortgage to 4% as an alternative. At 5%, you’ll pay $279,767 in complete curiosity over 30 years. At 4%, you’d pay $215,609 in complete curiosity, a distinction of greater than $64,000 (excluding curiosity you’ve already paid to your present lender). It additionally shaves about $180 off of your month-to-month mortgage cost.

In case your prepayment penalty is similar as the primary instance ($5,900), you can also make cash for the charges again in about 33 months ($5,900 / $180). If the charges will stay at 4%, it’s doubtless extra value ready a 12 months or two—however not at all times. Charges can fluctuate continuously, so deciding whether or not it is best to refinance depends upon how a lot you’ll save in the long run. 

Forms of Prepayment Penalties

There are two widespread varieties of prepayment penalties you might encounter:

Laborious penalties: Prepayment penalties that apply to each refinancing and promoting a property.
Gentle penalties: Prepayment penalties that solely apply to refinancing your property.

The best way to Keep away from Prepayment Penalties

Fortunately, avoiding prepayment penalties isn’t too troublesome. Right here’s how:

Work with a lender that doesn’t cost a prepayment penalty.
Get a mortgage estimate that doesn’t embrace a prepayment penalty.
Negotiate the cancellation of a prepayment penalty together with your present lender.

You can too make further funds sometimes with out getting charged a prepayment penalty. Normally, these funds solely seem in your lenders’ radar if you make a considerable cost (i.e., 20% of your principal or extra). 

Are Paying Prepayment Penalties Price It?

The reply could be sure or no and is set on a case-by-case foundation. Test together with your lender to see in case your contract has a prepayment penalty clause. Typically it’s value it to maintain making common funds till the clause expires or to speculate your cash elsewhere.

Notice By BiggerPockets: These are opinions written by the writer and don’t essentially signify the opinions of BiggerPockets.