Early repayment penalty: what it is and how to avoid it

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When you have a mortgage, you can decide to refinance the loan or pay off early to save money. But this can incur a prepayment penalty, which you should keep in mind when comparing home loans.

See what the penalty for early repayment of a mortgage is, how much they can cost, and how to avoid them:

What is a prepayment penalty?

The prepayment penalty is some commission mortgage lenders charge when you repay the loan in whole or in part before the due date. This is an incentive for the borrower to repay mortgage for the full term for the creditor to receive interest.

Prepayment penalties usually don’t apply when you make multiple additional payments here and there. Instead, prepayment penalties are usually triggered when you repay the entire loan ahead of schedule

For example, you mortgage refinancingSelling a home or using a lump sum on a loan, usually over three years, may incur a prepayment penalty.

Tip: Before paying off your mortgage, it is a good idea to check your loan documents to see if a prepayment penalty applies.

Types of prepayment penalties

There are two types of prepayment penalties – soft prepayment penalties and hard prepayment penalties. Here is a short description:

  • Soft prepayment penalty: Applies when you are refinancing your mortgage or paying off the majority of the balance. You can sell your home or make larger payments to speed up payment deadlines without applying a penalty.
  • Penalty for hard prepayment: Applies if you are refinancing a mortgage, paying most of the principal balance, or selling a home.

The type of prepayment penalty you pay may depend on type of mortgage you get and practice your lender.

Prepayment Penalty Limits

For fixed rate mortgages, lenders can include provisions for early repayment penalties for the first three years, with restrictions on the amount of fees. But they must also offer an alternative loan that does not include prepayment fees.

Lenders cannot charge prepayment fees on the following types of mortgages:

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How much are prepayment penalties?

Early repayment penalties vary by lender, but here are some typical formulas for determining this fee:

  • Percentage of outstanding loan balance: You may need to pay a small percentage, for example 2%, of the remaining loan amount when you repay the loan during the first two or three years of the loan term. For example, if you owe $ 200,000 and the penalty is 2%, you pay a $ 4,000 prepayment penalty. However, your lender may limit the prepayment penalty to a specific dollar amount.
  • Interest for a certain number of months: Some lenders base the penalty on the amount of interest you would pay if you kept the loan longer. For example, if you refinance, you may be required to pay interest in the amount of six months.
  • Fixed fee: You may have to pay a fixed amount, such as $ 2,000, to pay off the loan before maturity.
  • Sliding scale: This model is based on the length of the loan term. For example, if you pay off your mortgage in the first year, you owe 2% of the outstanding balance; interest is reduced to 1% of the balance if you repay the loan within the first two years.

Why lenders charge early repayment penalties

You might think that all mortgage lenders want their money back as soon as possible. But when lenders issue mortgage loans, they expect to receive interest over the life of the loan, usually 15 to 30 years. When borrowers pay back their mortgages before the due date, they lose all interest.

Early repayment penalties help lenders because they discourage borrowers from paying off their mortgages quickly. They also help lenders recover some of the money they would have received in interest.

How to avoid prepayment penalties

The best way to avoid prepayment penalties is to take out a loan that does not provide any payments. Lenders cannot charge these fees from:

  • FHA loans
  • VA credits
  • USDA loans
  • Adjustable rate mortgages
  • High interest mortgages

They may also choose not to charge this commission on regular loans.

Check for a prepayment penalty

When you apply for a mortgage, the lender must provide you with loan appraisal in three days. This standardized document contains detailed information about the loan, including associated costs and the ability to change the terms of the loan.

When you have received your loan estimate, see page 1 in the “Loan Terms” / “Early Repayment Penalty” section. In the field under the question “Does the loan have this function?” the document will say yes or no. If it says yes, then your loan has an early repayment penalty.

The loan estimate will also indicate the amount of the fine and the time of its application.

Loan estimate - early repayment penalty

That is why it is important to compare offers from several lenders to find the best loan conditions.

about the author

Kim Porter

Kim Porter is an expert in loans, mortgages, student loans and debt management. She has been featured in US News & World Report, Reviewed.com, Bankrate, Credit Karma and others.

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