Prepayment Penalty
What is a prepayment penalty?
A prepayment penalty is a fee charged by lenders for paying off your loan early, either by selling your home or by refinancing.
How it works
Usually, the prepayment penalty only applies if you sell or refinance within three to five years of getting your original mortgage. The fee can work in one of several ways: it can be a flat percentage of the outstanding balance, such as 2 percent; it can start at, for instance, 3 percent, and then decline by a percentage point each year; or the penalty might be expressed as equal to a certain number of months of interest.
Why it matters
If you are a prime borrower – meaning you have good credit and a reasonable down payment – accepting a prepayment penalty on a loan can sometimes lower your rate. Whether or not it makes sense to do so depends on rate trends: if rates fall a lot in the first few years after you get your loan, the prepayment penalty may not make it cost effective to refinance. If rates go up or stay about the same, then accepting the lower rate in exchange for the penalty could be a good thing. No matter what, you should always check ask whether or not a loan carries a prepayment penalty when you’re shopping for a mortgage.
The prepayment penalty also matters if you already have a mortgage and are thinking of selling or refinancing. If you aren’t sure if your current mortgage carries a prepayment penalty, check your loan documents, or call your lender. If your mortgage does have a penalty, you may want to hold off on refinancing. At the very least, factor in the added cost when you calculate closing costs.
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