Question:

If an adjustable rate mortgage is paid off early would there be a huge ARM prepayment penalty?

Answer:

Prepayment and refinancing of Adjustable Rate Mortgages (ARMs) involves a penalty only if the borrower provides written consent to the lender at the time of signing the loan agreement. You should check your loan agreement to see whether there is a prepayment clause that makes you liable for a payment if you return the loan before it is due.

Because ARM prepayment penalties are usually portrayed as a small fraction of the balance (e.g. six months interest on remaining balance), sometimes borrowers think that they will not cost much. This is very dangerous as prepayment penalties can be up to several thousand dollars.

Consider a 3/1 ARM (initial rate for 3 years, readjustment every 1 year afterwards) with an initial rate of 6%. Suppose at the end of year 3 the borrower decides to refinance the original loan and at that time the remaining balance is $100,000. If the loan has a prepayment penalty of 6 months interest on the remaining loan, the penalty would be $3000.

With ARMs, lenders usually charge the following types of prepayment penalties.

  • Firm Prepayment Penalty: This penalty is applied if the borrower either sells the home or pays the loan off before the agreed upon period.
  • Soft Prepayment Penalty: This prepayment penalty is applied if the borrower only if he/she wants to refinance their mortgage. Selling the house does not have any penalty.
  • Partial Prepayment Penalty: The penalty is applied if the prepayment exceeds a certain fraction of the original balance e.g. 20% of the loan.

Lenders sometimes slip the prepayment penalty clause in the mortgage agreement without touching on it extensively. The only way you can make sure that nobody takes advantage of you is to go over all the details with your loan officer.

Make sure that the contract you sign has only the terms that you have agreed upon and that if there is a prepayment penalty, you know about it. Otherwise getting out of the loan may become far too expensive.

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