A 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.