Tutorial on Whether to Accept a Prepayment Penalty

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18 April 2006

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. Prepayment penalties usually decline or disappear with the passage of time, seldom applying after the fifth year. For additional details, see Mortgage Prepayment Penalties.

Borrowers in the sub-prime market are required to accept penalties. Some lenders offer it to other borrowers as an option on fixed-rate mortgages (FRMs) in exchange for a lower rate.

If you are taking an FRM, have a long time horizon, and would prefer not to be bothered refinancing if interest rates go down, you are the perfect candidate to exchange a prepayment penalty for a lower rate. If it turns out, contrary to your expectations, that you pay off the mortgage within the penalty period, the penalty is tax deductible. The option is not widely available, however.