prepayment-penalty-basicsWhy on earth would you be willing to pay for the privilege of paying off your home loan? That is essentially what you will be agreeing to, if your finance company attempts to include a prepayment penalty in the terms of your loan. The simple advice is don’t walk away, run!

Good For Lenders Bad For Borrowers

Banks and other finance companies are in the business of making money. And thank goodness they are too! Because they provide an excellent service that has enabled consumers to reach high levels of prosperity, of which previous generations could not have dreamed.

Lenders like to be able to count on a monthly income and it annoys them when a borrower pays off a loan. That means the lender has to find another borrower to lend their funds to. From the time that you pay off your loan until the time they receive the first payment from the next borrower, they’re losing interest.

Prepayment Penalty Basics: The Short Answer Is No

Fortunately the lending market is big enough and competitive enough to keep this sort of thing in check. So, prepayment penalties are mainly for borrowers with poor credit histories and limited options, also known as the sub-prime lending market.

For the rest of us, penalties can be easily avoided by shopping around. One of your most important demands of a lender must be that they do not include any prepayment penalties.

The Long Answer Is Also No

When you are in the market for a home loan and you are choosing a lender, make sure that you establish that there are no clauses in their contract that amount to a prepayment penalty. If you have poor credit you may not be able to avoid penalties and they usually contain certain limits, such as the first five years.

A penalty may be triggered for even a partial repayment of principle within the penalty period. The particular terms of prepayment penalty clauses will vary according to the policies of each lender, again, shop around.

Since lenders are attempting to put cash into assets and earn some interest, the loss of interest is what prepayment penalties are meant to recover. That means they are generally expressed in terms of that lost income, say, six months of interest on 85% of your loan balance. That can be a pretty big chunk of change! Add on broker’s fees and transfer taxes and all the other costs of selling a home and you’re easily losing money, even in a rising market.

In Summary

Avoid prepayment penalties if at all possible because they will do exactly what they are supposed to do: Tie you into a home loan with unfavorable terms. Most homebuyers should be able to avoid them with ease. It just requires that you pay close attention when you are reviewing the terms of the loans on offer and decline any that require you to pay for the privilege of paying off your home loan.