What are hard vs soft prepayment penalty on mortgage loans and can you avoid them?Answer:
To explain hard vs. soft prepayment penalty on a mortgage loan, imagine that you sign a home loan and you have a prepay penalty clause of 4-month interest due if you sell the property within three years, or if you refinance. That will be a hard penalty.
A soft penalty is when you are penalized only if you refinance prior to a fixed period (usually 2 to 5 years). However, no penalty charge will be incurred if you sell the house right after you got the mortgage loan and bought that home.
Can you avoid hard or soft prepayment penalties on a mortgage?
Sometimes lenders would quote different options for a prepay penalty - say, for 1, 2, .., 5 years. In exchange, your mortgage interest rate will be reduced - a longer penalty period is accepted for lower rate.
Mortgage prepayment penalties serve a different purpose for different types of homebuyers. For example, a borrower who plans to keep the house may take the longest prepayment penalty term and have their rate greatly reduced, compared to borrowers who refuse a penalty clause.
This is exactly the difference between investors and standard homebuyers. An investor is usually buying property to fix and sell within a year. They wouldn't accept prepayment penalty at all, or perhaps only the shortest one, as they don't need the rate to go down.
Prepayment penalties would hold for a longer time and can bring the interest rate down significantly, if the property is going to be owner-occupied for a long period of time.
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