A prepayment penalty is a clause in your mortgage contract where the borrower agrees to pay the penalty if he pays down or pays off the mortgage earlier than agreed. Some mortgage contracts restrict your ability to make prepayments before a set amount of time. In general, if you agree to a prepayment penalty, you will get a better interest rate on your loan.
There are two types of prepayment penalties. A hard prepayment penalty is charged when the mortgage is paid off because the borrower is selling the home or refinancing the house before the set amount of time has passed. A soft prepayment penalty is charged when you refinance your mortgage.
By prepaying your mortgage, you are cutting down the interest charges on your loan. Lenders use prepayment penalties to protect their investments. All unscheduled payments mean that the lender will not profit off that principal amount. Furthermore, these penalties also serve to deter borrowers from refinancing their mortgage at a lower interest rate.
Prepayment penalties vary from lender to lender. Some lenders use a fixed percentage while others can use a sliding scale based on how long you have had your mortgage. Furthermore, some penalties apply if the mortgage is paid off within two years, while other penalties are charged if the mortgage is paid off within five years.
Lenders must disclose all prepayment penalties at the time of closing.
For example, one prepayment penalty may be a charge of 80% of six-months of interest-only mortgage payments. Let’s say you borrow a $100,000 loan at 4.5% interest. After 30 years, you will end up paying $82,405 in interest.
In this example, your monthly mortgage payment is $507. To calculate your prepayment penalty, six months of that payment is $3,042. 80% of this amount is $2,433.60. Your prepayment penalty is approximately $2,440.
On the other hand, if you added $75 to your monthly payment to pay down your loan, you would repay your mortgage almost seven years sooner. Furthermore, you would end up paying $60,804 in interest. That’s a savings of nearly $22,000 in interest payments. In this case, it was worth the cost of the prepayment penalty.
The main benefit of prepaying your mortgage is the interest payment savings. By paying off the principal balance earlier, you do not pay interest on that amount. Additionally, you will shorten your loan term and own your home sooner.
You must weigh the costs of your penalty against your savings to make sure that prepaying makes financial sense. This requires careful calculations and knowing the terms and conditions of your loan contract.
Additionally, it is not advisable to prepay your mortgage if you cannot maintain liquidity. In other words, you should be sure to have an emergency fund first to protect you if from potential financial hardship. Keeping liquidity allows you access to your money when you need it, instead of tying it up in your mortgage.