In the United States, the vast majority of conforming mortgages will be for either 30 or 15 years. During the lifespan of the mortgage, the mortgage holders will be responsible for making monthly payments, which typically include principal payments, interest payments, taxes, and, in some cases, private mortgage insurance (PMI). Prepayment penalties are often included in mortgages, and they may be applied in various ways. However, homeowners are often able to avoid or bypass these fees altogether.
While the mortgage's principal payments and taxes cannot be avoided, homeowners with mortgages will often find that interest payments sometimes can be minimized. And in some cases, depending on the interest rates, how long one has had the mortgage, and the initial down payment, these interest payments might represent as much as half of the mortgage.
One of the ways to avoid these interest payments is to pay off the mortgage early. However, there are often some overlooked complications that come with early payments, including prepayment penalties. In this guide, we will discuss the most important things needed to know about paying off a mortgage early, making it easier to decide whether doing so will truly be in one's best interest.
What is a Mortgage Prepayment Penalty?
A prepayment penalty is a penalty imposed on mortgage borrowers who choose to pay either all or part of their mortgage early. Only some mortgages include prepayment penalties and the portion of mortgages that do include these penalties has decreased over the past few years. Taking a look at a first time home buyer's guide can help understand how prepayment penalties actually work.
If a mortgage does include a prepayment penalty, that doesn't necessarily mean paying off part or all of the mortgage early will be a bad idea—after all, these prepayment penalties are almost always much less than the money needed to have to instead pay via interest. However, these penalties are certainly something to keep in mind when making final calculations. It is also a good idea to check whether a prepayment penalty will apply whenever considering applying for a mortgage, even if one thinks it's unlikely to ever pay it off early.
Why Lenders Charge a Prepayment Penalty
At first, the very existence of a prepayment penalty might seem a little bit counterintuitive. After all, isn't paying off debts ahead of time the financially responsible thing to do? Why should one ever be penalized for choosing to do so?
Well, while paying off a mortgage early can be financially beneficial in many situations, doing so reduces the lender's expected return on investment. Lenders issue loans with the expectation they will be paid on time and at an agreed-upon schedule. It is not uncommon for lenders to charge close to the home's initial value in interest over the life of the mortgage. When the mortgage is closed early, they will miss out on potential future cash flows and, in return, will expect to receive some compensation. This is especially true for mortgages that are closed very early after the lender just paid loan initiation costs. For better or for worse, this is where a prepayment penalty might apply.
How Much is a Prepayment Penalty on a Mortgage?
As suggested, the prepayment penalty on a mortgage will usually end up being much less than the amount of interest one would have to pay if they continued paying the mortgage as scheduled. So don't give up on the idea of paying a mortgage off early just yet. However, the total cost of a prepayment penalty can vary a lot, depending on the lender, so check and see how the prepayment penalty will be calculated (when applicable).
There are currently several different ways lenders calculate a prepayment penalty. One method is charging a pre-determined percentage of the remaining mortgage balance. Typically, this percentage will be somewhere around 2 or 3 percent. When this method is used, the earlier one is in their mortgage, the higher the prepayment penalty will ultimately be.
Another method is to charge a pre-determined portion of interest. For example, if one decides to pay off the remaining mortgage balance, a lender might charge the interest payments that would have paid for the next six months as the prepayment penalty. Depending on the structure of the mortgage, this may or may not be better than the previous option.
It is also possible that a lender will charge a flat fee for all of its borrowers who choose to prepay, such as $5,000, though this particular method is not very common in the housing market. One may, however, find this method used for other types of loans, such as auto loans and personal loans.
The most common method for calculating a prepayment penalty is the sliding scale method. With this method, one will be a fixed percentage of the remaining mortgage, depending on how many years remain. A common sliding-scale applied by lenders might require borrowers who pay off their mortgage in the first year to pay a 2 percent fee and borrowers paying off their mortgage in the second year or later to pay a 1 percent fee. This method is known as a "2/1" prepayment structure. This method is popular because borrowers who pay off their mortgage very early might actually cause lenders to lose money (due to loan initiation and other fixed costs).
Prepayment Penalty Example
Clearly, there are several different ways to calculate prepayment penalties. These penalties are likely outlined in the mortgage contract (though it is also pretty easy to overlook certain clauses). Let's take a look at some prepayment penalty examples.
We'll start with the most common method: the sliding scale payment structure. Suppose one has $200,000 remaining on a mortgage and is ready to pay it all off. The lender uses a 2/1 prepayment model, with the drop in penalty occurring after the first year. This means that if one pays off the remaining amount in the first year, the prepayment penalty will be $4,000 (which is 2 percent of $200,000). If it's after the first year, however, the prepayment penalty will be only $2,000 (or 1 percent of $200,000).
Suppose a lender uses the monthly interest model in order to determine the prepayment penalty. In this case, the prepayment penalty will equal the sum of the next six months' worth of interest payments. If the monthly mortgage payment is currently $2,000 per month, the amount of money going towards interest over the next six months might look like: $860, $855, $850, $845, $840, $835, respectively. To determine the prepayment penalty, all one would need to do is add up these six figures, which in this case, would equal $5,085.
How to Check for a Prepayment Penalty Clause
In every state, it is required by law for lenders to disclose any prepayment penalties to any potential borrowers. However, in the excitement of closing on a home, it can be very easy to overlook specific clauses in mortgage papers, or, if it's been a while, one may have simply forgotten.
If the mortgage papers are available, carefully look through them for any references to a prepayment penalty. If there is a digital copy of the mortgage (something that is increasingly common), using the "Control+F" function to search for keywords might save a little bit of time. If the mortgage papers are unclear or ambiguous, one can always contact the lender and ask (they are required to explain). There might also be instances in which a prepayment penalty will be illegal, including when the owner is more than three years into the mortgage or the mortgage is sponsored by the government (FHA, VA, USDA, etc.).
Mortgage Rates Forecast: Housing Market Predictions for 2024
Exploring Balloon Payments: The Risks and Rewards
You Have Found the Prepayment Clause. Now What?
Once one have found the relevant prepayment clause, the next thing to do is decide if prepayment makes sense. Start by determining the method used to calculate the potential penalty (and if it's confusing, ask the lender). After that, calculate how much money there is in savings by accepting the penalty and paying the loan off later. Also remember that, even though there is a mortgage agreement in place, terms can potentially be negotiated away or avoided via a mortgage refinance.
Do the Math
It's important to do the math when making the final decision because while paying off the mortgage in full will make sense in some situations, it won't really make sense in others. One will want to calculate both what the prepayment penalty will be and the amount of interest subject to pay until one reaches the point where no prepayment penalty will apply.
If there is only one month of interest until the borrower is "in the clear", this single month of interest payments will likely be less than the prepayment penalty, meaning it would be unwise to pay the penalty rather than wait. Also, one should keep in mind the opportunity cost of paying now—if there is a large amount of money to invest (and generate a return) until the penalty window closes, that might be a consideration instead.
Leave Refinancing as an Option
If one is looking to pay off a mortgage (in part or in full), they might also want to consider refinancing. There are many different benefits that can come with refinancing, which is a process that can sometimes cost less than accepting a pricy prepayment penalty.
When one refinances their mortgage, they will often have the ability to add a clause that nullifies the prepayment penalty, which will give them at least a little bit of future financial flexibility. Additionally, they might also be able to secure a lower interest rate (though interest rates are rising, they are still near all-time lows), restructure the mortgage, and achieve other financial goals as well. Whether refinancing is right will depend on the current alternatives (such as a buyout), how long planned to live in the home, and various other factors.
Be Ready to Negotiate
Contrary to popular belief, mortgage terms are not "set in stone." Rather, these terms merely create a basic legal framework – it may be possible to alter them in the future. Though one will be required, by law, to generally comply with the mortgage terms initially agreed to, there is almost always room for negotiation.
Depending on the relationship with the lender - and other factors, such as the general state of the economy—one might be able to negotiate away some or all of the prepayment penalties. Lenders would be even more willing to negotiate if the borrower made all historical mortgage payments in full and on time. There are a lot of variables that can affect how effective the negotiating process will be. However, if one is willing to make a counteroffer, or suggest they are switching to a different lender, or find other methods for creating leverage, they will likely find themselves in a much better position.
How to Avoid a Prepayment Penalty on a Mortgage
While many mortgages include prepayment penalties—which can be applied in a variety of different ways—these fees are often an obstacle that homeowners can easily navigate or even avoid altogether. Understanding mortgages will ultimately lead to possible long-term financial stability.
Be sure to take a close look and understand what prepayment penalties, if any, might apply to the particular mortgage. There will almost always be accessible options available including refinancing the mortgage, negotiating current terms, or—if all else fails—simply waiting until the prepayment window closes, which is usually just three years.
And, in some cases, it might be in the financial best interest to simply accept the penalty and move on. Nevertheless, it is always a good idea to explore available options and compare each of their pros and cons.
Frequently asked questions
Will My Credit Score Change by Prepaying My Loan?
Prepaying a mortgage will rarely have a negative effect on a credit score and, in some cases, will have a positive effect. However, it is usually a good idea to confirm how prepayments are reported to the credit bureaus before making a final decision.
Does it Make Sense to Pay Off My Mortgage Early?
Whether to pay off a mortgage early will depend on one's current financial situation and long-term goals. By doing so, one can avoid future interest payments. However, there might also be prepayment penalties, which is why one should consider all options before deciding.