What is a prepayment penalty and when is it triggered?


A prepayment penalty is a provision of the mortgage agreement which states that if the borrower pays off the loan entirely before the originally agreed period of the loan, he/she will have to pay a fee to the lender.

Prepayment penalties are generally expressed as a percentage of the outstanding balance at the time of prepayment, or interest over a specified number of months.

When is a prepayment penalty triggered?

Some prepayment penalties apply to refinancing, because when you refinance you essentially pay off your old loan with a new one. These are called soft prepayment penalties. Some prepayment penalties apply if the borrower refinances or sells the home; these are called hard prepayment penalties.

Usually, prepayment penalties decline or disappear with the passage of time. Seldom do they apply after the fifth year. Partial prepayments of up to 20% of the balance usually are allowed in any one year without a penalty.

Why are prepayment penalties applied?

Usually prepayment penalties are applied on loans that have a higher interest rate for e.g. Subprime loans. As the interest rates (hence rates of return) are high on these loans, lenders do not want borrowers to get out of the deal.

That is why they attach subprime prepayment penalties so that if a borrower has better financing options some time down the road, he/she cannot get out of the mortgage deal without compensating the lender. 

A Word of Caution

Lenders sometimes slip the subprime 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 the loan officer. Make sure that the contract you sign has only the terms that you have agreed upon. Otherwise getting out of the loan may become far too expensive.

Mortgage rates hit their lowest since 1955. Ask the home loan experts we recommend Quicken Loans how to take advantage of them.
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