How to avoid a mortgage prepayment penalty

If you’re thinking about taking advantage of a lower interest rate, a mortgage refinance may be in your future. But before you make the switch, you may want to know how to avoid a mortgage prepayment penalty – a hefty fee some lenders charge for repaying your loan too early. Here's everything you need to know about the penalty fee before making any financial decisions.

What is a mortgage prepayment penalty?

A mortgage prepayment penalty is exactly what it sounds like: a fee you're charged for paying off your mortgage loan before the end of your term. Mortgage lenders make money by charging borrowers interest and when the lender agrees to fund the loan, they're planning to make money over the entire term: typically either 30 or 15 years. If you pay the loan off early, the bank makes less money, so many opt to charge borrowers prepayment penalties for paying it off in full.

Prepayment penalties are meant to incentivize homeowners away from refinancing in the earliest (and highest-interest earning) years of the loan, with many mortgage lenders reducing the penalty percentage each year until it goes away completely after a set length of time.

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How to avoid a prepayment penalty

The only way to completely avoid a prepayment penalty is to ensure your lender doesn’t charge one. Many lenders advertise “zero prepayment penalties” in their marketing as a way to entice borrowers to work with their institution. Part of interest rate shopping and conducting proper due diligence is to shop rates with multiple lenders and examine the loan estimates.

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It’s important to factor prepayment penalties into your decision of whom to borrow with, particularly if you’re planning on paying off the mortgage early or like to refinance when rates change to maximize saving on interest.

What are prepayment penalty costs?

The lender with the lowest interest rate may not make sense financially if you’re planning to pay the mortgage early (or would, at least, like the option to do so).

For example: A lender charges 2% prepayment penalty in the first two years on the outstanding loan balance, and 1% in years three to five. A homeowner who has a $300,000 mortgage left on a $400,000 home could expect to pay a $6,000 penalty if they refinance or pay off the loan in years one and two, a $3,000 penalty in years three through five, and zero penalties if they refinance or pay off the loan after five years.

When calculating if it makes sense to refinance, factor in any penalties into total amount saved. On top of closing costs and origination fees on the new loan, $3,000 to $6,000 could impact your decision of if refinancing makes sense at all, or your total “break-even” point on the new loan.

Of course, if you have a hard prepayment penalty that triggers upon the sale of the home, it may make sense to pay the penalty in order to move on to the next chapter. In the event of a refinance with a significant drop in interest rate, it can also make sense to pay the penalty if the total amount of interest saved significantly outweighs the penalty plus closing costs on the new loan.

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What else do I need to know about prepayment penalties?

There are two different types of prepayment penalty: soft and hard.

• A “soft” mortgage prepayment penalty is only triggered during a mortgage refinance.
• A “hard” mortgage prepayment penalty can occur for a mortgage refinance or for when a homeowner sells the property.

The good news is that making extra payments, or putting a little extra toward the balance each month or once a year, usually isn’t enough to trigger a prepayment penalty. But, again, double-check this in your loan agreement. Most lenders allow borrowers to pay off up to 20% of their mortgage in a year without any type of penalty.

Wondering if your loan has prepayment penalties and where to find it? Prepayment penalties are clearly laid out in the loan agreements and any disclosures documents, which is why it is important to read any and all paperwork from the lender before you sign.

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