What is mortgage prepayment penalty?

A mortgage prepayment penalty is a fee you pay to your lender if you pay some or all of your loan off early. While your mortgage broker or loan officer may not always directly inform you of a mortgage prepayment penalty on your home loan, it will always be contained in your loan origination contract. Typically, the mortgage prepayment penalty is imposed to protect the profits of the mortgage company, since paying off your loan early means they collect less interest.

Prepayment penalty periods vary depending on the type and length of the loan. Mortgage brokers will sometimes offer a lower interest rate on a standard 30 year fixed rate mortgage in exchange for a prepayment penalty that expires after three to five years. During that time, you cannot refinance or pay off your loan without paying a penalty - usually between 2 and 3 percent. If you don’t plan on moving or refinancing in this time, this may be a good deal for you.

Mortgage prepayment penalties are more troublesome with bad credit or subprime mortgage loans. For example, a lender may only agree to give you a subprime mortgage loan if you agree to a prepayment penalty for the life of the loan. This works against your favor, since after two years of making timely payments towards your mortgage, your credit score will improve and you’ll be eligible for a lower interest mortgage. However, the lender traps you by preventing you from refinancing without paying a hefty mortgage prepayment fee.

Sometimes, mortgage prepayment penalties are somewhat flexible. For example, while you may not be able to refinance or completely pay off your loan, you may be able to make extra payments towards your mortgage periodically without incurring penalties. Mortgage lenders may also allow prepayments without penalty for certain situations, such as selling the home.

No matter what you do, never accept a mortgage prepayment penalty without a fight. Usually, there is some quid pro quo with a mortgage prepayment penalty. It’s usually the x factor that determines whether you can receive a loan or not, or whether you can get a lower interest rate or not. Make sure that you are getting something in return for agreeing to a mortgage prepayment penalty. Or, better yet, try to avoid having a mortgage prepayment penalty written into the loan documents in the first place.

For business loans and balloon loans, you won’t likely be able to avoid prepayment penalties, since these are usually very short term in the first place.