Home Mortgage Essentials: Understanding Prepayment Penalties in a Home Mortgage

The Prepayment Penalty Defined

This is a penalty that allows a lender to charge you a percentage of your loan balance if you pay off your mortgage debt before its term is up. This most often applies to payoffs that happen early in the life of a loan, and don’t apply generally after about five years. This mechanism allows the lender to have steady income from your loan for a length of time.

There are Some Benefits

The image of a prepayment penalty is often negative, but agreeing to pay this can mean a lower interest rate for those with good credit. You should talk to your loan representative about this option, and make sure it could benefit you. Also make sure if the penalty applies to selling the home or refinancing (or both). Prepayment penalties limit refinancing as well as home sales.

Loan Requirements

Some loans require a prepayment penalty. If you have bad credit you will likely be a sub-prime candidate, and you may not be eligible to eliminate the penalty from your contract. The prepayment penalty helps a lender reduce risk on bad-credit loans. Over time and under certain conditions your lender may permit you refinance your sub-prime mortgage and eliminate the prepayment penalty from the contract.

You Might Have No Choice in the Process

While the sub-prime borrowers may not have a choice in the matter, they may be able to negotiate other aspects of the penalty, like the percentage, the amount, or the length of time it’s in effect. Remember that long penalty periods may be a red flag in your sub-prime loan—this is a way for unscrupulous mortgage lenders to hold bad credit loan holders into lengthy and expensive (and bad) loan agreements.

Make Sure You Understand the Terms of a Loan Agreement

To make sure you know your prepayment conditions, ask your loan representative to explain it to you verbally. Make sure you understand everything and it’s all in the contract. When you get your note at the closing, don’t make the mistake of not reading it! Discipline yourself to read every word, and if you have questions or concerns—or there is something there that was not told to you up front—make it known and make them explain it.

Beware of Certain Lenders

Be careful of lenders who may not disclose prepayment penalties to you, then add the paperwork at the closing. They may be hoping you don’t notice it, or claim to have forgotten to tell you about it. Don’t let them do this to you. In many states prepayment penalties are already illegal.

Final Notes

Be an informed and smart home-buyer. Don’t just know what all the paperwork means: read it every time it’s handed to you, and sign nothing until you thoroughly understand it.