Avoiding Prepayment Penalties

Prepayment penalties, also known as cancellation fees, are one of the classic pitfalls that await the unwary borrower. All too often, a homeowner selling or refinancing their home has been stunned to discover that they first have to pay a penalty of several thousand dollars to get out of their current mortgage.

A prepayment penalty is a fee assessed for paying off part or all of your mortgage ahead of schedule. Often, borrowers aren’t even aware their mortgage has one until they trigger its provisions – although required to be disclosed by law, they often get lost in the stacks of papers that need to be signed at closing.

Fortunately, prepayment penalties are going to be a lot easier to spot on new mortgages from now on. The new Truth in Lending form, which takes effect Feb. 1, 2010, specifically requires lenders to declare whether a mortgage includes a prepayment penalty or not. Of course, that won’t do much good for unwary homeowners who already have prepayment penalties on their current mortgages and don’t realize it.

Prepayment penalties are often portrayed as a bad thing to be avoided at all costs. In reality, they’re just one more thing to be negotiated when obtaining a mortgage. Accepting a prepayment penalty may enable you to get a lower mortgage rate or obtain a “cost-free” mortgage where you pay nothing up front and the closing costs are rolled into the loan itself. They really only become a negative when they’re sprung upon unwary borrowers by hiding them among the boilerplate of the mortgage agreement – which the new Truth in Lending form is supposed to make much harder to do.

A prepayment penalty, just like it sounds, is a penalty for paying off your mortgage ahead of schedule. Typically, the penalty is 2-4 percent of the loan balance, which can be a pretty hefty bite – 2 percent of a $200,000 loan is $4,000. If you’re looking to refinance your loan, a prepayment penalty can pretty much wipe out any savings you hoped to realize.

Banks like to require prepayment penalties to ensure they earn a minimum return off a loan – if you pay your mortgage off after one year, they don’t earn much money from it. The good news is, most prepayment penalties expire after five years – and they often shrink over time, so the penalty for paying your loan off after four years is less than it would be if you paid it off after two.

Accelerated payments can trigger penalty

Prepayment penalties can hit you in several ways. First, you could get hit by a prepayment penalty if you try to refinance your mortgage after less than five years – since refinancing means taking out a new mortgage to pay off your old one. You can also get hit if you sell your house within a few years of buying or refinancing it. A prepayment penalty can also affect you if you try to pay your loan off faster by making additional payments – although most prepayment penalties aren’t triggered unless you pay off at least 20 percent of the balance in a single year, a few may penalize you for any accelerated payments.

Accepting a loan with a prepayment penalty included may not always be a bad deal, though. If you plan to stay in the home at least five years, you may be able to get a slightly lower rate with a prepayment penalty. A “no-cost” mortgage or refinance, in which the closing costs are rolled into the loan in the form of a higher interest rate, will nearly always require a prepayment penalty, to ensure the bank earns its money back.

"Hard" vs. "soft" penalties

There are different types of prepayment penalties as well. A “soft” prepayment penalty is not imposed if you sell the home or make accelerated payments, only if you refinance into a new mortgage within the first few years. A “hard” prepayment penalty, on the other hand, is imposed regardless of the reason for paying early.

The key thing is to be sure you understand the terms of your mortgage and understand what you’re giving up and gaining in return for accepting one. If you think it’s highly unlikely you’ll refinance or pay the loan off early, you might be able to shave a bit off your interest rate by accepting a prepayment penalty. But if you may be moving or refinancing within a few years, you may be better off paying a higher rate with no potential penalty attached for paying off early.