What is the Prepayment Penalty on a Mortgage?
Prepayment Penalties: What Are they?
When entering a loan agreement of any kind, many people have one goal in mind: paying off the loan as quickly as possible. No one likes to owe money -- even if it is for a huge investment that couldn’t be made otherwise (like a house, for example). On the other side of the coin, you would assume that lenders would want to be repaid in full as soon as possible as well. After all, wouldn’t you like to get that $12 back from your old college roommate?
Surprisingly, not all lenders feel that way. Sometimes, there are clauses in mortgage contracts that stipulate penalties for repaying the loan too fast. That's right, you could get charged extra for paying back what you owe ahead of schedule. As ridiculous as it may sound, prepayment penalties exist and are more common than you think.
Prepayment Penalties Explained
A prepayment penalty is exactly what it sounds like: a penalty fee charged to the borrower for paying off the mortgage loan too quickly. This can include paying off the loan through refinancing or selling the home. Of course, the fee charged must clearly be stated in the loan agreement, as well as the period of time that prepayment fees may be applied. The details of the clause vary by lender, and not all mortgage agreements have prepayment penalty clauses.
Why Do Prepayment Clauses Exist?
Just like mortgage insurance, the prepayment penalty is meant to protect the lender’s interests. Literally. Interest serves as the “cost” of a loan, and lenders would much rather collect interest payments on a monthly basis than have larger payments made that don’t include interest on the full payment. Additionally, it helps them reduce the risk of any financial loss due to refinancing or sale of the home within the first five years following closing.
Prepayment penalties must be disclosed to borrowers at closing, but it doesn’t hurt to ask when shopping around for a home loan. After all, every lender and loan agreement are different, and you should always know what you’re getting into when it comes to investing in a home.