Prepayment Penalty BasicsMortgage prepayment penalties are still applied to certain mortgage accounts, even though they are not as common as they were a few years ago. Fundamentally, a prepayment penalty is an agreement between you and a lender that you will pay extra to the lender if you repay your loan earlier than the contracted period.

They do not apply only to mortgages but can be applied to any form of loan that has been arranged to be repaid over a stipulated period of time. Many people believe them to be unfair, but mortgage prepayment penalties can actually be a good thing for you. Here is why, and how prepayment penalties generally work.

Why a Mortgage Prepayment Penalty is Applied

If you have agreed to repay your mortgage over a certain period of time, say 30 years, then your lender will know how much income they will make over that period.  That is the interest you are paying. Your mortgage loan will be amortized over the 30 years so that you pay the same every month.

A lot depends on the amount of your loan. Let’s take the example of a $200,000 mortgage at 3.8% interest over 30 years. In the final 20 years you would pay a total of $66,670 in interest. If you cleared your mortgage loan after 10 years, that is what the lender would lose in total that is a major reason for mortgage prepayment penalties being applied if you clear your mortgage early.

Optional Mortgage Prepayment Penalties

In many cases, but not all, you will be given the option of a prepayment penalty. If you agree then you will be offered more favorable terms, generally in the form of lower interest rate. Lenders will offer this because they know that either their income is secure or that you will pay if you clear the loan early. Such penalties can therefore be of benefit to you and save you a fair amount in your monthly repayment.

However, don’t get worried about having to keep your mortgage for 30 years.  Such agreements are usually restricted to a period of less than 5 years. That is when lenders make most money on interest. In the above example, you would have paid £36,219.20 in interest after 5 full years and $29,279.78 after 4 years. Lenders are happy to allow you clear your mortgage after that.

When Mortgage Prepayments Occur

When interest rates are falling, and borrowers are on a fixed rate, it makes sense for many to refinance their loan with a lender offering a lower interest rate. Original lenders then lose their projected interest earnings. The penalty insures against this – to an extent. When a prepayment penalty is applied for such refinancing, it is known as a ‘soft’ penalty.

If a homeowner decides to sell their home, the original mortgage loan must be repaid from the proceeds. A penalty applied in this case is known as a ‘hard’ penalty. Many lenders apply soft penalties to protect themselves from dropping rates. Others might apply both, and it is important that you are fully aware if you have a mortgage prepayment penalty, and if so, what its terms are.

Your mortgage loan contract will tell you whether or not you have such a penalty. They are not as common as they once were, and as already stated, they tend to operate only for the first few years of the mortgage period.  They are more likely to be mandatory if you have a poor credit score, because such borrowers have a history of refinancing quickly after their FICO scores improve.

Mortgage prepayment penalties can work to your advantage if you are on a variable or adjustable rate mortgage and are offered a rate reduction to agree to such a penalty. However, there are situations when you should think carefully; negative equity could lead you to being unable to pay the penalty. You could not then sell your home because you would have to maintain your mortgage.