Prepayment Penalties
A new homebuyer should always understand the exact terms of the loan they are assuming, and one point to watch for is a prepayment penalty. A prepayment penalty is a condition of the loan that indicates the borrower will be charged a fee if they want to pay the loan off early. These penalties were created to benefit the lender and protect them from losing interest money on the duration of a loan. If the loan is paid off early, the lender will not make as much money as they had initially anticipated when granting the loan.
Although it is not common to find a conventional loan that includes a prepayment penalty clause, they do still exist. Most large lenders will not require a prepayment penalty, but some of the smaller banks who rely on receiving interest for the life of the loan might include this in the mortgage terms. FHA and VA loans will never have a prepayment penalty and will allow the borrower to repay the loan at any time.
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How a Prepayment Penalty Works
When a prepayment penalty clause is included in the mortgage, most lenders will not allow the borrower to pay off more than 20% of the loan each year. The prepayment penalty is often 80% of six months interest on the loan. This means that the faster you pay off a loan, the higher the penalty will be. For example, let’s you plan to pay off a loan with a principal balance of $500,000. This loan has an interest rate of 5%. That means 80% of six months’ worth of interest would be $10,000. This is a hefty price for paying off a loan early.
Downsides of a Prepayment Penalty
A prepayment penalty can be detrimental in certain situations. For example, if the homeowner wants to refinance their mortgage, they are technically paying off the original mortgage and opening a new one. Additionally, in the homeowner decides to sell their home before building a certain amount of equity they could be penalized with prepayment penalties.
When it Makes Sense to Pay the Penalty
There are certain situations in which paying of a loan might make financial sense, even if you incur a prepayment penalty. If you decide to refinance to a loan with a lower interest rate, you might end up saving money in the long run. If you currently have a loan with unfavorable terms, or a balloon loan, you may benefit from paying off the loan even with the prepayment penalty. It is always important to review the cost versus the benefit of paying off a loan if you have a prepayment clause.