Even the most carefully chosen mortgage may no longer be a fit if your financial situation changes, for example due to an increase in income or a disruption in it. You can choose to break your mortgage contract in certain situations, but doing so will result in a penalty for early mortgage payments.
Lenders use mortgage prepayment penalties to offset the interest they lose when a homeowner pays off part or all of their mortgage early. It’s important to know what prepaying your mortgage could cost you because these fees can vary greatly depending on the lender and type of mortgage.
Many homeowners are surprised to learn that there’s a penalty for paying off their mortgage early. This penalty, known as a prepayment penalty is a fee that some lenders charge borrowers who pay off their mortgage loan before the end of the loan term.
Why do lenders charge prepayment penalties?
Prepayment penalties are imposed by lenders as a safeguard against losing interest payments over the course of the loan. Lender risk is higher during the first few years of a loan term than borrower risk. The majority of borrowers have made minimal down payments in relation to the house’s value. That’s why lenders charge mortgage interest, which is protection from a financial loss.
If a borrower pays the loan off right away, the lender loses out on all the interest fees which were included in the loan as an incentive to them to give the borrower a loan.
How much is a prepayment penalty?
Although repayment penalties differ, there are some common models used to calculate them.
- Percentage of remaining loan balance: The lender will assign a small percentage, such as 2%, of the outstanding principal as a penalty fee if the payoff is made within the first 2 or 3 years of the loan term.
- X number of months’ interest: The borrower will pay a total of a certain number of months in interest, such as 6 months.
- Fixed amount: With this model, the lender writes in a set figure, such as $3,000, for paying off a loan within the first year. This is not typically used in mortgages.
- Sliding scale based on mortgage length: This is the most common model. Let’s use a sequential 2/1 prepayment penalty over the first 2 years of the loan as an example. If the mortgage is paid off during year 1, the penalty is 2% of the outstanding principal balance. If the mortgage is paid off during year 2, then the penalty is 1% of the outstanding principal balance.
How can I avoid a prepayment penalty?
There are a few things you can do to avoid a prepayment penalty:
- Negotiate a lower fee: If you decide to stick with your lender and the mortgage with the penalty, you can try to negotiate a lower fee.
- Switch to a different loan type or lender: Not all lenders charge prepayment penalties, so make sure to shop around and compare lenders to find the best mortgage option for you.
- Choose a lender who doesn’t charge prepayment penalties: Rocket Mortgage is one example of a lender that doesn’t charge prepayment penalties.
Should I pay off my mortgage early?
Deciding whether to pay off your mortgage early is a personal decision. A few things to think about are your risk tolerance, your financial objectives, and the interest rate on your mortgage.
Paying off your mortgage early can save you a lot of money on interest payments if your interest rate is high. Nonetheless, it might make more sense to keep your mortgage and make other investments if you have other financial objectives, like investing or saving for retirement.
The bottom line
Before you choose a mortgage, verify whether the contract includes a prepayment penalty. You should also consider lenders like Rocket Mortgage that don’t charge prepayment penalties.
Ready to explore your mortgage options? You can start the approval process today.
Frequently Asked Questions
Q: What is a prepayment penalty?
A: A prepayment penalty is a fee that some lenders charge borrowers who pay off their mortgage loan before the end of the loan term.
Q: Why do lenders charge prepayment penalties?
A: Lenders charge prepayment penalties to protect themselves against the loss of interest payments over the life of the loan.
Q: How much is a prepayment penalty?
A: Prepayment penalty costs vary, but there are some typical models for determining penalty cost.
Q: How can I avoid a prepayment penalty?
A: There are a few things you can do to avoid a prepayment penalty, such as negotiating a lower fee, switching to a different loan type or lender, or choosing a lender who doesn’t charge prepayment penalties.
Q: Should I pay off my mortgage early?
A: Deciding whether to pay off your mortgage early is a personal decision. There are a few things to consider, such as your financial goals, your risk tolerance, and the interest rate on your mortgage.
Additional Resources
How much are mortgage prepayment penalties?
With closed, variable-rate mortgages, the prepayment penalty is typically three months’ interest on the amount prepaid. Some lenders will base the penalty on your mortgage rate, others might use their prime rate. The more you exceed your prepayment limit, the higher your penalty will be.
Let’s say you have a 5% variable-rate mortgage and go over your annual prepayment limit by $10,000. Your penalty might be a few hundred dollars. However, you will pay thousands of dollars in penalties if you pay off your mortgage in full during the remaining years of the term.
The prepayment penalty for a closed, fixed-rate mortgage will usually be equal to the interest rate differential (IRD) or three months’ interest.
Although lenders frequently do their own IRD computations, this is how they typically work when borrowers completely pay off a mortgage:
- A mortgage product that has a term length comparable to the remainder of your mortgage term is found by your lender. Your lender will look into its current selection of three-year fixed-rate mortgages if, for instance, you have a five-year mortgage with three years remaining.
- Your mortgage rate is deducted from the current posted rate for the relevant product to get the IRD rate. If your lender’s three-year, fixed mortgage rate is 6. 4%, whereas your initial rate was 5%, so the IRD rate will be 201 4%.
- Your monthly amount owed is then calculated by multiplying the IRD rate by the balance that remains and dividing the result by twelve. This amount would be roughly $467 if your mortgage balance is $400,000 remaining.
- After that, the monthly payment is multiplied by the number of months left in your term. That works out to 36 months in this case, so a prepayment penalty of roughly $16,800 would apply.
Your penalty for going over the annual prepayment cap on a closed, fixed-rate mortgage shouldn’t be nearly as much as it would be if you paid it off in full. Because you’ll be prepaying a smaller amount, the lender may only charge you three months’ interest.
Going beyond your annual prepayment limits
Prepayment privileges are typically included in closed mortgages, allowing borrowers to pay off their mortgage ahead of schedule up to a lender-set maximum. This may include annual increases to your regular mortgage payment or lump-sum payments toward your principal. These prepayments will typically be a predetermined percentage of your original loan amount.
However, should you exceed the boundaries established by your lender, there may be a 2010%%20ceiling on the amount you can increase your monthly payment, or a 2015%%20cap on your annual lump-sum payment allowance of 20%0%E2%80%94%20you will be subject to a prepayment penalty.