Prepayment Penalties: Foul or Fair?

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Mpj040179500001A prepayment penalty is a fine charged to a borrower if they payoff their mortgage before a certain time period (typically 2-3 years).   The fine is commonly 6 months interest (just shy of six months mortgage payments less your monthly taxes and insurance) and may vary.   

Most often, the prepayment penalty is "hard", meaning that it will be assessed whether someone is refinancing or selling their home prior to the time period being met.   Sometimes, the prepay may be a "soft" penalty and is forgiven in the case of a person selling their home, but charged if the borrower is refinancing.

For example, on a $200,000 loan amount with 6% interest, a prepayment penalty based on 6 months interest would be $6,000.  It’s expensive.   It may be a tax deduction since it is prepaid mortgage interest, however, if you’re paying if off for a refinance, it is also taking away home equity.

Some times, prepayment penalties are required for the certain mortgage program.  This is most often the case with subprime mortgages.   This has potential to cause a dicey situation if a subprime borrower has 100% financing, like an 80/20 with an adjustable rate mortgage, and the borrower does not work on improving their credit before the prepayment is over and the ARM adjust.   Subprime loans are becoming tougher to qualify for and  some subprime lenders have closed their doors.

If the borrower has good credit and equity or a down payment, then the prepayment penalty should be optional and the borrower’s choice.   The prepayment penalty may be used to lower the mortgage interest rate.  If this is the case, the Loan Originator should show the borrower the difference between the two rates and payments and fully explain the terms of the prepay.    If the "a paper" borrower is not receiving the benefit of the choice between having or not having a prepayment penalty, then it could very well be lining the pockets of the loan originator.    If your loan originator is telling you that you must have a prepayment penalty, and you have great credit PLEASE GET A SECOND OPINION.

Prepayment penalties need to be disclosed to the borrower up front.  This should not be a surprise to a borrower at signing.   Review your Federal Truth in Lending statement that accompanies your Good Faith Estimate.   There will be a sentence with a box stating:

Prepayment:  If you pay off your loan early, you  ( X ) may (   ) will not  have to pay a penalty.   

If the "may" box is checked, you have a prepayment penalty on the proposed loan scenario.   If the loan originator did not disclose this to you upfront, contact them to find out if and why there is a penalty.

The Good Faith Estimate and Federal Truth in Lending are required to be provided to you from the loan originator within 3 days of providing you a rate quote.   At signing, you will also receive a disclosure regarding the prepayment penalty.

Whenever a prepayment penalty is optional, even if it is to lower a borrower’s interest rate, I am opposed to them.  You never know when life will happen and you need to sell your home or if mortgage interest rates improve and you want to take advantage of the lower rate.    With some programs, such as subprime loans, the prepayment penalty may be required.   If this is your scenario, ask the loan originator if the prepayment penalty can be "cashed out" or reduced upfront. 

Regardless of your situation, your loan originator should fully explain all of your options to you.   Should you decide to obtain a second opinion from a Mortgage Planner, simple provide them with your credit scores, loan-to-value (sales price or value of the home and the loan amount), documentation (is it easy to document your income and assets or do you need a no-income verifier type of loan), and program type.   You may also consider providing the lender with a copy of your good faith estimate to review from the first loan originator.  The lender who provides you a second opinion should not  have to re-pull your credit at this stage.

It’s your money, your assets, your home and your responsibility to make sure you understand (ask questions…don’t be shy) your mortgage scenario.    Prepayment penalties are fair IF you understand how and why you have one with your mortgage.  If it’s helping someone with an iffy credit past (assuming the new home owner is now responsible with their credit, debts and cash flow) become a home owner, then I’m all for it.   If it’s to increase the commission of a loan originator, it’s FOUL.

Comments

  1. Hi I have been trying to Refi my home to no avail due to a pre payment Penalties I even tried a FHA and because of the per payment I came up to 97.5 and to do a FHA you must be 97.1. Is there any home for me and is there anything that I can do. Please Help in Arizona.

  2. Alice, you can try contacting the lender who has the prepay to see if they will waive it. If you wish, I can refer you to a Mortgage Professional in Arizona. I’m licensed only for Washington State properties.

  3. Hi and thank you that would be great I have even asked them if they could do a loan modification and they told me no. so went to Ace MTG and he thought he could help me and because of the pre payment I came out just a little to high for the FHA I sent a letter to my lender and even had the broker send over the paperwork we have not heard anything. Im not late on any of my payments as of yet but I cannot continue to work so much over time to make these payments and I just don’t know what to do so any help that you can offer would be great thank thank you so much.

  4. Ms. Porter, what if the company that holds the prepayment penalty (in my case Decision One) is one of those sub-prime mortage places that went under? I contacted the company that Decision One was affiliated with (HSBC) and they told me to take up the pre-payment penalty issue with my lender (Countrywide)since Decision One is no longer. Does this mean that my issue is now with Countrywide? Or can I expect Countrywide to give me the run-around?

    My case is very similar to Alice’s above. I’ve never been late with my payment (not over 30 days, that is). But my husband and I are killing ourselves to get this mortgage paid before it hits our credit report every month. What happens if we just sell the house and pay the amount we owe minus the penalty? Since Decision One is gone, can Countrywide claim the panelty money?

  5. Nikki,
    It sounds like Countrywide owns your Note and they have the right to collect the prepayment penalty.

    It’s worth a shot to contact Countrywide to see if you can negotiate anything. I understand Bank of America (who is supposedly taking over Countrywide) is wanting to help out homeowners.

    Good luck!

  6. I guess I am having a little trouble understanding prepayment penalties. I read an article on prepayment penalties on badcreditmortgages.com’s help blog, but I’m not sure exactly when it would be beneficial to pay the fees. Can you tell me an example?

  7. Hi Mia,
    I know on the rate post for A Genenous People, I wrote that prepayment penalties could reduce a rate. 9 times out of 10 they do not. I do not recommend seeking out a loan with a prepayment penalty only because they are very costly to get out of.

  8. Thanks for the answer, but I have another quick question. Do all home loans have prepayment penalties? Again, thanks for the great info.

  9. Hi Mia, Most loans do not have prepayment penalties. Currently you can tell by the Federal Truth in Lending (mentioned above) and by an addendum to the Note (you don’t want to wait until closing/signing to find out). Whenever you ask a lender for quotes, ask them if there is a prepay and avoid it whenever possible.

  10. I sold my home in 2007. The mortgage on the house was an ARM. When I was getting the mortgage I specifically insisted that I did not want the prepayment penalty and was assured I will not have one. However the box was checked and I did not realize that it was until I was selling and when I got my closing figures I paid over $6000. in prepayment penalty. The loan was with Countrywide. Is there anything I can do to recoup the funds?

  11. Greta, you may want to contact an attorney however my personal opinion (and I am NOT an attorney) is that it’s probably too late. Your best negotiating power was before you closed on the mortgage on the home you sold. In addition to the box marked prepayment, you should have had an addendum to your Note that you signed at escrow disclosing the prepay. Do you have that?

  12. lmgriff24@aol.com says:

    I have had the same problem with BENEFICIAL who is also HSBC, i have been trying to work with them to waive/return the prepayment penalty, and they are VERY DIFFICULT to work with and could care less if you are able to refinance to get a lower rate to be able to pay your mortgage and keep your house..I have been trying to work with them for over 2 MONTHS, and still haven’t gotten anywhere.

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