When you take out a mortgage to buy a home, you are borrowing a large sum of money from a lender that you agree to pay back over a long period of time, often 15 or 30 years, and the lender makes money off the interest you pay on the loan over those years. However, some lenders include a prepayment penalty clause that allows them to charge you a fee if you pay off all or part of the mortgage early before the full term is up. If they sound pesky, it’s because they are, and they’re crucial for anyone with a mortgage to know about.
What is a prepayment penalty and why do they exist?
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A prepayment penalty is an extra fee, typically a percentage of the remaining mortgage balance, that you would owe the lender if you prepay your mortgage. This creates a disincentive for you to pay the loan off faster than scheduled.
From the lender’s perspective, a prepayment penalty protects them from losing out on the interest income they expected to receive if you paid off the loan over the full term. When you get a mortgage, the lender is counting on receiving that interest revenue over 15 to 30 years. If you can afford to pay the loan off in 5 to 10 years, the lender doesn’t make as much profit. Prepayment penalties help lenders reduce the risk of borrowers refinancing and prepaying when interest rates drop. It ensures they still make a minimum amount even if you pay the loan off early.
Not all mortgages come with prepayment penalties, though. More consumer-friendly lenders may choose not to include them to attract borrowers who want the flexibility to prepay without added fees.
How to avoid a prepayment penalty
The best way to avoid getting hit with a prepayment penalty is to be aware of the terms before you get a mortgage and choose a lender that doesn’t charge one. Be sure to read the fine print carefully.
If you already have a mortgage with a prepayment penalty provision, find out what the specific terms are. Prepayment penalties are not permanent—they expire after a certain period of time, typically a few years. The penalty may also have limits, like only being charged for a certain amount of the loan prepaid each year.
By understanding exactly how the prepayment penalty works, you can plan accordingly. You may be able to make additional principal payments up to the limit each year to pay down the balance faster without triggering the full penalty initially. And once the penalty period expires, you can look into options to fully prepay without added fees.
While prepayment penalties can be an unwanted surprise, doing your research upfront and understanding what you’re agreeing to can help you avoid them when possible or mitigate the costs if you do have to pay one.