What is a Prepayment Penalty and How Can You Avoid One?
Key Takeaways
- If extra payments toward principal are how you plan to be out from under the mortgage years early, check first whether your lender charges a prepayment penalty, a fee some lenders apply when a loan is paid off early, because a borrower who sends periodic lump sums or clears the balance in full prevents the lender from earning interest income, and whichever lender writes the loan has to disclose that fee before you close on the home.
- Federal law prohibits prepayment penalties on several loan programs, FHA and USDA loans among them, and the early payoff fees that are allowed carry financial and time restrictions, according to Forbes, and a given lender may charge the penalty only where a borrower pays the loan off in the first few years after closing. Standard with mortgages until the 2008 housing crisis, such fees are less common today, though you might still come across a lender that charges them.
- Ask how the fee would be calculated before assuming you know what it will come to, since lenders use different criteria, some structuring the penalty by interest and others by a percentage of the borrower's loan balance. Timing counts too: prepayment penalties usually start near 2% if a loan is repaid within the first year, and you can then expect a decrease of 0.5% each year until the penalty goes away, so waiting longer to pay off leaves a borrower owing less in penalty.
- In the loan estimate and the closing documents lies the answer to whether a prepayment penalty applies, which a borrower can establish without help from anyone, and where no mention of such a fee turns up in either, going straight to the source and asking the lender settles the matter. Since knowing could ultimately decide whether paying a loan off goes ahead at all, the strategy for avoiding the fee is to work with a lender who does not charge one.
There’s no better feeling for a homeowner than paying off their mortgage. Not only do you eliminate what’s likely your biggest expense, but you can put those funds toward retirement, other debt, or something fun. It’s why many homeowners are making extra principal payments to get rid of their mortgage faster.
However, you need to check if your lender charges what’s called a prepayment penalty first. The last thing you want to deal with is a surprise fee because you chose to pay off your home loan.
Continue reading as we further discuss prepayment penalties and how you can avoid one as a future homeowner.
What are mortgage loan prepayment penalties?
The Consumer Financial Protection Bureau defines a prepayment penalty as a fee that some lenders charge if you pay off your loan early. Keep in mind that a borrower who applies periodic lump-sum payments toward their mortgage or pays it off in full prevents a lender from earning interest income. The lender you work with must disclose this fee before you close on your home.
Prepayment penalties used to be standard with mortgages until the 2008 housing crisis. Though such fees are less common today, you might still come across a lender that charges them. You can potentially save yourself thousands of dollars in unnecessary costs by understanding any prepayment penalty with your loan and the implications surrounding it.
The good news is that federal law prohibits lenders from incorporating prepayment penalties on several types of loan programs, including USDA and FHA loans. Plus, according to Forbes, the early payoff fees that are allowed include financial and time restrictions. For example, a certain lender may only charge a prepayment penalty if a borrower pays off their loan in the first few years after closing.
How does it work?
Some lenders lose money if a borrower refinances or sells their home soon after taking out a loan. Including a prepayment penalty causes a borrower to think twice before moving forward with either process. Again, these fees vary by lender and loan type, so communicate with your mortgage consultant well in advance.
How much will you end up paying?
Lenders use different criteria to calculate their prepayment fee. While some lenders structure the penalty costs by interest, others look specifically at a borrower’s loan balance percentage. There’s also the possibility of a lender charging a flat fee.
It’s safe to say that prepayment penalties usually start near 2% if you repay your loan within the first year. You can then expect the penalty to decrease by 0.5% each year until it goes away. This means that the longer you wait to pay off your mortgage (whether through lump-sum payments, refinancing, or selling), the less you’ll owe your lender in prepayment penalties.
Avoid a prepayment penalty altogether
We hope you now have a better understanding of prepayment penalties. At this point, you’re probably wondering if there’s a way around this fee. The answer could ultimately decide whether you proceed with paying off your loan.
The best strategy for avoiding a prepayment penalty is working with a lender who doesn’t charge one. You can find this information yourself by checking the loan estimate and closing documents once you get to that point. If you struggle to locate any mention of a prepayment fee, go straight to the source and ask your lender.
At American Financing, we never charge prepayment penalties on our loans. We believe that every loan we create should help our borrowers achieve their financial goals. Charging an unnecessary fee because you want to pay off your loan sooner would go completely against our principles.
What happens when you pay off your mortgage?
No prepayment penalty is the assurance you need to pay off your remaining mortgage balance. Once you make your final payment, you should receive the following documentation in the mail from your lender:
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A canceled promissory note showing that you repaid your loan in full
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A certificate of satisfaction explaining that you no longer owe your lender funds
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The deed to your house
Remember to be patient while you wait for this paperwork, as your lender must also alert the city or county recorder that you are now the sole owner of your residence.
Two things you will need to account for immediately after the payoff of your mortgage are your property taxes and homeowners insurance. When you were making monthly payments on your loan, your mortgage servicer may have handled both expenses through your escrow funds. Borrowers assume responsibility for homeowners insurance and property taxes after they pay off their loans.
