How to Avoid Mortgage Prepayment Penalties


|10 min read

If you are like most people, you probably don’t want to pay any mortgage prepayment penalties. Unfortunately, many people do not know how to avoid them. In this article, we will discuss some of the ways that you can avoid one.

What is a Prepayment Penalty?

A prepayment penalty is a fee that is charged by the lender if you pay off your mortgage early. This fee is typically a percentage of the total loan amount, usually as low as 2%, but can be much higher. For example, if you have a $100,000 mortgage and a 4% prepayment penalty, you would owe the lender $4,000 if you paid off the mortgage early.

What Causes Prepayment Penalties?

Prepayment penalties are typically charged by lenders who offer teaser rates or other types of low introductory rates. These rates are usually only available for a limited time, and the lender wants to make sure that they recoup the interest that they would have otherwise earned if you kept the mortgage for the full term.

Why Do Lenders Charge a Prepayment Penalty?

Lenders charge prepayment penalties because they want to make sure that they recoup the interest that they would have earned if you kept the mortgage for the full term. If you pay off your mortgage early, the lender misses out on this interest.

When Are They Charged?

Prepayment penalties are typically charged if you:

  • Refinance your mortgage within a certain number of years (usually 2-3 years)
  • Sell your home before a certain number of years (usually 3 years)
  • Make a lump sum payment on your mortgage that exceeds a certain percentage of the original loan amount (usually 20%)

Federal Prepayment Penalty Rules

There are also federal rules that apply you should be aware of. These rules came about after the mortgage crisis of 2008 and were included in the Dodd-Frank Act of 2010.

In order to charge a penalty, the loan must meet all of the following requirements:

  • They can only be charged on mortgages where the APR does not increase after taking out the loan.
  • The loan can only be a “qualified mortgage,” which are loans that have stable terms and cannot – for example – have interest-only payments or negative amortization.
  • The mortgage cannot be a higher-priced loan, meaning the loan has a higher APR than the Average Prime Offer Rate.

Additionally, a prepayment penalty can only apply within the first 3 years of the loan, and the amount of the fee is capped at 2%, but reduced in the final year. For example, a penalty of 2% applies in the first and second years and a penalty of 1% in the third.

Finally, a lender who offers you a loan with a prepayment penalty must also offer you loan terms that do not have a penalty. This allows you to compare the two and choose the option that is best for you.

What States Do Not Allow Prepayment Penalties?

Most states allow prepayment penalties, but there are a few that do not. These states are:

  • Maine
  • Massachusetts
  • Nevada

Some states may have other restrictions, such as limiting the amount that can be charged. You should always check with your state’s laws before agreeing to a mortgage that has a prepayment penalty.

How to Avoid Prepayment Penalties

If you are shopping for a mortgage, be sure to ask the lender if there are any penalties for paying your mortgage off early or for making a lump sum payment. Many lenders will not charge a prepayment penalty if you pay off your mortgage within the first few years.

You can also avoid prepayment penalties by refinancing your mortgage. If you refinance your mortgage, you will essentially be taking out a new loan to pay off the old one. While your current lender may still charge the penalty, the new lender may be willing to cover it, so be sure to ask!

Finally, you may be able to negotiate with your current lender to waive it. This is typically only an option if you are facing financial hardship or if you are going through a divorce.

Reasons to Not Pay Your Mortgage Off Early

While there are some benefits to paying off your mortgage early, there are also some drawbacks that you should be aware of. You should look at your overall financial picture, not just your debt.

Some of the reasons you may not want to pay your mortgage off early include:

  • You could lose out on valuable tax deductions – The interest you pay on your mortgage is tax-deductible. If you pay off your mortgage early, you will no longer be able to deduct this interest from your taxes.
  • You may have other debts with higher interest rates – If you have other debts, such as credit cards or student loans, that have a higher interest rate than your mortgage.
  • You may want to invest the money instead – If you invest the money you would use to pay off your mortgage, you may be able to earn a higher return than the interest you are paying on your loan.
  • You may need the money in an emergency – If you have a low-interest mortgage, it may be better to keep the money in savings in case of an emergency.

Paying off your mortgage early is a personal decision and there is no one-size-fits-all answer. You should weigh the pros and cons and make the decision that is best for you and your family.

Prepayment penalties can be avoided if you are mindful of them when shopping for a mortgage. Be sure to ask the lender about any prepayment penalties before you agree to take out a loan. You may also be able to avoid them by refinancing your mortgage or by converting it to a fixed-rate mortgage. If you are facing financial hardship, you may be able to negotiate with your lender to have the prepayment penalty waived.

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