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Save Your Money! What Are Loan Prepayment Penalties?

prepayment penalty
You may want to think twice about paying off your mortgage early if there’s a prepayment penalty clause in your contract.

When financing a big-ticket item like a car or home, you often dream of paying off your loan early, whether that’s by getting an inheritance from a beloved aunt or uncle, winning the lottery, or, the most realistic option for most of us, paying extra beyond your required payment each month. But when you choose to pay extra, or if you want to sell or refinance your Raleigh, NC, home within the first five years of your contract, it’s best to check with your lender: You may be subject to a prepayment penalty, which is a fee that gets assessed if you pay off your mortgage early or head down the refinance route.

How much will the prepayment penalty cost me?

Prepayment penalty fees can typically cost between 2% and 4% of the overall loan and are usually applied against borrowers who repay their mortgage in less than five years. Some are flat rates, while others are on a sliding scale, depending on how early you pay off the loan. For example, if you decide to refinance a 2-year-old mortgage with a remaining balance of $250,000 and you face a 4% prepayment penalty fee in your contract, you would owe the original lender $10,000 for paying off the loan early. (Generally, lenders charging a prepayment penalty fee will allow you to pay 15% to 20% of your loan off each of the first five years without charging the penalty.)

Why do lenders charge these fees?

Prepayment penalty fees are included in mortgage contracts because they protect the lender from the loss of paid-interest revenue over time. When lenders decide to finance a mortgage, they hope to get interest income for years to make a profit. Adding the prepayment penalty fees safeguards them against early refinancing or a home sale within the first two to five years after closing. Also, prepayment penalties may be added as a way for lenders to recover some profit if they swayed you their way with a lower-than-average interest rate.

The fees are becoming less common, with many larger banks not using them. And an important note: If you have an FHA-backed loan and are reading this, good news — prepayment penalty fees aren’t allowed by the FHA.

Soft vs. hard fees and lender disclosure

Note that there are two kinds of prepayment penalty fees: soft and hard. The soft fees allow you to sell your home at any time without penalty, but if you choose to refinance your mortgage, you’re subject to the prepayment penalty. Hard fees, meanwhile, charge you a penalty whether you sell your home or refinance.

Mortgage lenders are required to disclose prepayment penalties at the time of closing on a new mortgage. If you’re thinking about selling your home or refinancing, you should read your documents carefully to see if your mortgage has a prepayment penalty or early payment penalty and then talk to your broker to clarify the terms and conditions around the clause.

Have you suffered prepayment penalty fees for paying off your home early or selling or refinancing the property? Share in the comments!

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