What Is a Prepayment Penalty?

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By Justin McHood

NEW YORK (Zillow) —

Although not as common as they were just a few years ago, there are still various loan programs that give people an option to have a prepayment penalty.

If you get a mortgage that has a prepayment penalty, it means that you are agreeing in writing that should you “prepay” the mortgage before a specified period of time (usually less than 5 years) then you agree to pay a specified “penalty” to the lender. Some prepayment penalties require you to agree to the penalty only under certain circumstances (for example, you may not have to pay if you sell your house), others require you to pay the penalty regardless of the reason you prepaid the mortgage.

When a lender agrees to loan you money, they have calculated their expected return on the mortgage and built it into their models, even calculating the period of time that they expect you to have the mortgage before it “prepays.”

Although winning the lottery happens, the most common reason that someone would prepay a loan off before the maturity is that they were able to find a loan offered by another lender with a lower interest rate and refinanced out of their current mortgage and into a new mortgage.

When interest rates drop, many people refinance and prepay numbers go up dramatically.

How To Tell If You Have A Prepayment Penalty On Your Mortgage

The easiest way to find out if you currently have a prepayment penalty is to dig out the paperwork you have from when you signed your final paperwork and look for your mortgage note. Most often, there will be wording in your note that outlines the prepayment penalty terms. Sometimes there will also be something called a “Prepayment Penalty Rider,”, but it will vary depending on when you closed your loan and your lender.

Are Prepayment Penalties “Bad”?

Some loans never allow a prepayment penalty. For example, there is never a prepayment penalty on an FHA loan, VA loan or USDA loan. Does this mean that prepayment penalties are bad?

Prepayment penalties aren’t bad — in fact, I tend to view them as a potentially good thing. For example, let’s say that in exchange for agreeing to a prepayment penalty a homeowner:

  • Is aware of the prepayment penalty, what it means and what the terms of the prepayment penalty are

and

  • Received a lower interest rate and/or lower closing costs

and

  • Is given the choice of having the prepayment penalty

Then, a prepayment agreement can be a good thing for both homeowner and lender.

The simple reason many people think that prepayment penalties are “bad”? Because, in the past, people haven’t been made aware of these three things.

Justin McHood works for Academy Mortgage and is based in Chandler, AZ. He is a contributor to Zillow Blog and has conversations about mortgages whenever he can. Learn more about Justin at http://www.mortgagecommentator.com.

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