Penalties For Early Payment
October 12, 2001, Revised November 17, 2004, Revised April 18, 2007
A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Penalties are usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest.
Usually, prepayment penalties decline or disappear with the passage of time. Seldom do they apply after the fifth year. Partial prepayments of up to 20% of the balance usually are allowed in any one year without a penalty. A penalty that applies to a home sale as well as a refinancing, is a "hard" penalty; if it applies only to a refinancing, it is a "soft" penalty.
Questions about prepayment penalties come from several types of borrowers, as illustrated by the letters below.
"We are committing ourselves up to the limit of our capacity to buy the house we want. Our broker said we could reduce the rate from 7% to 6.75% if we accepted a prepayment penalty. This would reduce our payment by $35 a month, which would help a lot. Should we?"
Probably. The rate quotes indicate you are a prime borrower -- meaning your credit is good and/or you are making a very large down payment. Prime borrowers can usually get a better interest rate if they accept a prepayment penalty. Lenders, and the investors who buy loans from lenders in the secondary market, are willing to accept a lower rate in exchange for a prepayment penalty. The benefit of a prepayment penalty to them is that it discourages refinancing if interest rates decline in the future.
Most prime borrowers avoid prepayment penalties, either because they can or because they are never offered the option. Loan officers usually press to close as soon as possible, and offering options slows down the process. The upshot is that many prime borrowers who would elect a prepayment option if they understood it, never get the chance.
You may be a good candidate because you attach a high value to the lower rate. The question you must consider is what you are giving up? How large is the penalty? How many years must elapse before it goes away? And does it apply only to refinancing -- you don’t want to be subject to penalty if you sell your house. A 2-3% penalty during the first 3-5 years, payable only on a refinancing, is a reasonable price to pay for a 1/4% reduction in rate.
"Because I have very bad credit, I agreed to pay 11% for a 30-year mortgage. Friends have warned me to avoid a prepayment penalty, but when I ask the loan officer about this, he says that the lender absolutely requires it. Do I have any options?"
Probably not. Because of your bad credit, you are a sub-prime borrower. Lenders generally demand prepayment penalties on sub-prime loans because the risk of refinancing is higher than on prime loans. Sub-prime borrowers profit from refinancing if their credit rating improves, even when the general level of mortgage rates does not change. Prime borrowers can profit from refinancing only if market interest rates decline.
If you make all your payments on time for the next two years, and assuming no change in the general market, you might be able to refinance your 11% loan at 7-8%. But your current lender wants to keep your 11% loan for more than 2 years. Because of high origination costs and high default costs, sub-prime lending is not profitable if the good loans walk out the door after only two years.
But that doesn’t mean you have no negotiating power. While you may not be able to negotiate away the penalty entirely, you will probably be able to negotiate the specifics. Tell the loan officer: "No longer than 5 years; no higher than 3%; partial prepayments up to 20% of the balance allowed in any year without penalty; no penalty on sale of the property." Be forceful but sweet, keeping in mind that the lender wants your loan to close.
"I’m one of those dupes who never read the note. I now find myself stuck with a 12% mortgage and a 5% prepayment penalty, which I can’t afford to pay. Is there any way to get out of it?"
The only way to get out of a contractual obligation is to induce the other party to the contract to let you out. But lenders rarely have a reason to waive a prepayment penalty. Considering that you are terminating a relationship with them to start anew with another lender, why would they? The lender will surely say "no" if you ask.
You might have a chance if the request comes from a more formidable source. Some sub-prime borrowers have found a community group willing to intercede on their behalf. If you convince the community group that the original terms were unreasonably onerous, they just might persuade the lender to rewrite the note.
The letter above was from a borrower who had been victimized by contract chicanery: the practice of surreptitiously slipping a provision disadvantageous to the borrowers into the note. (Ordinarily, the borrower does not see the note until closing, and probably does not read it then. )Judging from my mail, prepayment penalties are the most common objective of contract chicanery. It can easily be prevented, see How to Shop For a Mortgage and Disclosure Rules on Mortgage Prepayment Penalties.
“My lender has requested an addendum to my note that he calls a soft prepayment penalty. Basically it states that if I prepay more than 20% of the loan within 5years I will need to pay a penalty equal to six months' interest. If the property is sold I can have this penalty waived. It is unlikely that I will want to refinance my 6% fixed-rate loan, so why would the lender request such a clause? Should I accept it?”
No. This lender evidently priced your loan without a penalty clause, and now wants to insert it without any quid pro quo. Don’t let him.
When the lender sells your loan in the secondary market, it might be worth 1% more with the prepayment penalty clause than without. That would, roughly, double his profit on the deal. But a prepayment penalty should carry a benefit to you – perhaps a 1/8% reduction in the interest rate.
Your current intentions regarding refinance in the future are wholly irrelevant. If rates drop from 6% to 4%, you will probably refinance. Investors in the secondary market understand that, even if you don’t. It is why they are willing to pay a premium price for a penalty clause that discourages refinancing.
Assuming you negotiate a penalty with the lender, make sure a provision to waive the penalty if the house is sold is incorporated in the note. The lender who ends up owning your loan won’t know anything about any oral promises.
Prepayment penalties are prohibited on FHA and VA loans, and also on loans made by Federally chartered credit unions. These add to a small part of the total market. On all other loans, any restrictions are set by the state in which the property is located. These vary widely from state to state, and I don't have a compendium of these laws. I did find the following maintained by a lender, but I can't vouch for its accuracy. See http://www.greenpointmortgage.com/cld/PrepayMatrix.pdf
What Is a Mortgage Prepayment Penalty?
A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Penalties are usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest.
Usually, prepayment penalties decline or disappear with the passage of time. Seldom do they apply after the fifth year. Partial prepayments of up to 20% of the balance usually are allowed in any one year without a penalty. A penalty that applies to a home sale as well as a refinancing, is a "hard" penalty; if it applies only to a refinancing, it is a "soft" penalty.
Questions about prepayment penalties come from several types of borrowers, as illustrated by the letters below.
A Prepayment Penalty May Lower the Interest Rate on a Prime Loan
"We are committing ourselves up to the limit of our capacity to buy the house we want. Our broker said we could reduce the rate from 7% to 6.75% if we accepted a prepayment penalty. This would reduce our payment by $35 a month, which would help a lot. Should we?"
Probably. The rate quotes indicate you are a prime borrower -- meaning your credit is good and/or you are making a very large down payment. Prime borrowers can usually get a better interest rate if they accept a prepayment penalty. Lenders, and the investors who buy loans from lenders in the secondary market, are willing to accept a lower rate in exchange for a prepayment penalty. The benefit of a prepayment penalty to them is that it discourages refinancing if interest rates decline in the future.
Most prime borrowers avoid prepayment penalties, either because they can or because they are never offered the option. Loan officers usually press to close as soon as possible, and offering options slows down the process. The upshot is that many prime borrowers who would elect a prepayment option if they understood it, never get the chance.
You may be a good candidate because you attach a high value to the lower rate. The question you must consider is what you are giving up? How large is the penalty? How many years must elapse before it goes away? And does it apply only to refinancing -- you don’t want to be subject to penalty if you sell your house. A 2-3% penalty during the first 3-5 years, payable only on a refinancing, is a reasonable price to pay for a 1/4% reduction in rate.
A Prepayment Penalty May Be Required on a Sub-Prime Loan
"Because I have very bad credit, I agreed to pay 11% for a 30-year mortgage. Friends have warned me to avoid a prepayment penalty, but when I ask the loan officer about this, he says that the lender absolutely requires it. Do I have any options?"
Probably not. Because of your bad credit, you are a sub-prime borrower. Lenders generally demand prepayment penalties on sub-prime loans because the risk of refinancing is higher than on prime loans. Sub-prime borrowers profit from refinancing if their credit rating improves, even when the general level of mortgage rates does not change. Prime borrowers can profit from refinancing only if market interest rates decline.
If you make all your payments on time for the next two years, and assuming no change in the general market, you might be able to refinance your 11% loan at 7-8%. But your current lender wants to keep your 11% loan for more than 2 years. Because of high origination costs and high default costs, sub-prime lending is not profitable if the good loans walk out the door after only two years.
But that doesn’t mean you have no negotiating power. While you may not be able to negotiate away the penalty entirely, you will probably be able to negotiate the specifics. Tell the loan officer: "No longer than 5 years; no higher than 3%; partial prepayments up to 20% of the balance allowed in any year without penalty; no penalty on sale of the property." Be forceful but sweet, keeping in mind that the lender wants your loan to close.
Prepayment Penalties Are Rarely Waived
"I’m one of those dupes who never read the note. I now find myself stuck with a 12% mortgage and a 5% prepayment penalty, which I can’t afford to pay. Is there any way to get out of it?"
The only way to get out of a contractual obligation is to induce the other party to the contract to let you out. But lenders rarely have a reason to waive a prepayment penalty. Considering that you are terminating a relationship with them to start anew with another lender, why would they? The lender will surely say "no" if you ask.
You might have a chance if the request comes from a more formidable source. Some sub-prime borrowers have found a community group willing to intercede on their behalf. If you convince the community group that the original terms were unreasonably onerous, they just might persuade the lender to rewrite the note.
Contract Chicanery Often Involves Prepayment Penalties
The letter above was from a borrower who had been victimized by contract chicanery: the practice of surreptitiously slipping a provision disadvantageous to the borrowers into the note. (Ordinarily, the borrower does not see the note until closing, and probably does not read it then. )Judging from my mail, prepayment penalties are the most common objective of contract chicanery. It can easily be prevented, see How to Shop For a Mortgage and Disclosure Rules on Mortgage Prepayment Penalties.
Don't Gift a Prepayment Penalty to the Lender
“My lender has requested an addendum to my note that he calls a soft prepayment penalty. Basically it states that if I prepay more than 20% of the loan within 5years I will need to pay a penalty equal to six months' interest. If the property is sold I can have this penalty waived. It is unlikely that I will want to refinance my 6% fixed-rate loan, so why would the lender request such a clause? Should I accept it?”
No. This lender evidently priced your loan without a penalty clause, and now wants to insert it without any quid pro quo. Don’t let him.
When the lender sells your loan in the secondary market, it might be worth 1% more with the prepayment penalty clause than without. That would, roughly, double his profit on the deal. But a prepayment penalty should carry a benefit to you – perhaps a 1/8% reduction in the interest rate.
Your current intentions regarding refinance in the future are wholly irrelevant. If rates drop from 6% to 4%, you will probably refinance. Investors in the secondary market understand that, even if you don’t. It is why they are willing to pay a premium price for a penalty clause that discourages refinancing.
Assuming you negotiate a penalty with the lender, make sure a provision to waive the penalty if the house is sold is incorporated in the note. The lender who ends up owning your loan won’t know anything about any oral promises.
Prepayment Penalties and the Law
Prepayment penalties are prohibited on FHA and VA loans, and also on loans made by Federally chartered credit unions. These add to a small part of the total market. On all other loans, any restrictions are set by the state in which the property is located. These vary widely from state to state, and I don't have a compendium of these laws. I did find the following maintained by a lender, but I can't vouch for its accuracy. See http://www.greenpointmortgage.com/cld/PrepayMatrix.pdf