Dock David Treece is a former licensed investment advisor and member of the FINRA Small Firm Advisory Board. His focus is on breaking down complex financial topics so readers can make informed decisions. He has been featured by CNBC, Fox Business, Bl.
Dock David Treece ContributorDock David Treece is a former licensed investment advisor and member of the FINRA Small Firm Advisory Board. His focus is on breaking down complex financial topics so readers can make informed decisions. He has been featured by CNBC, Fox Business, Bl.
Written By Dock David Treece ContributorDock David Treece is a former licensed investment advisor and member of the FINRA Small Firm Advisory Board. His focus is on breaking down complex financial topics so readers can make informed decisions. He has been featured by CNBC, Fox Business, Bl.
Dock David Treece ContributorDock David Treece is a former licensed investment advisor and member of the FINRA Small Firm Advisory Board. His focus is on breaking down complex financial topics so readers can make informed decisions. He has been featured by CNBC, Fox Business, Bl.
Contributor Rachel Witkowski Correspondent/EditorRachel Witkowski is an award-winning journalist whose 20-year career spans a wide range of topics in finance, government regulation and congressional reporting. Ms. Witkowski has spent the last decade in Washington, D.C., reporting for publications i.
Rachel Witkowski Correspondent/EditorRachel Witkowski is an award-winning journalist whose 20-year career spans a wide range of topics in finance, government regulation and congressional reporting. Ms. Witkowski has spent the last decade in Washington, D.C., reporting for publications i.
Rachel Witkowski Correspondent/EditorRachel Witkowski is an award-winning journalist whose 20-year career spans a wide range of topics in finance, government regulation and congressional reporting. Ms. Witkowski has spent the last decade in Washington, D.C., reporting for publications i.
Rachel Witkowski Correspondent/EditorRachel Witkowski is an award-winning journalist whose 20-year career spans a wide range of topics in finance, government regulation and congressional reporting. Ms. Witkowski has spent the last decade in Washington, D.C., reporting for publications i.
Updated: Jul 1, 2020, 2:05am
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A prepayment penalty is a fee that lenders charge borrowers who pay off all or part of their loans ahead of schedule. These fees are outlined in loan documents and are allowed in certain types of loans, like conventional mortgages, investment property loans and personal loans. Fees typically start out around 2% of the outstanding principal balance and fall to zero over the first several years of a loan.
Prepayment penalties can be unwelcome obstacles for people trying to reduce their debt or build equity in their property. If you want to avoid these penalties, you can often do so by avoiding certain types of loans, paying off your loan after the fees phase out or by negotiating directly with your lender before closing on a loan.
A prepayment penalty, or “prepay,” is a fee that borrowers are charged if they pay off a loan within several years after taking out a loan. Lenders typically stop charging them after the loan has been in repayment for three to five years. Lenders charge these fees in order to dissuade borrowers from paying off or refinancing their mortgages, which would cause the lender to lose out on interest income.
Federal law prohibits prepayment penalties for many types of home loans, including FHA and USDA loans, as well as student loans. In other cases, the early payoff penalties that lenders can charge are permitted but include both time and financial restrictions under federal law.
Not many people can afford to pay off a loan just a year or two after taking it out. But a lot of people refinance their loans to take advantage of a lower interest rate or if their credit improves. Prepayment penalties can make it more expensive to refinance within the first several years after taking out a loan.
Prepayment penalties vary by lender and loan type. Some lenders don’t charge them; in other cases, they’re restricted. When prepays are charged, they’re only charged during the first few years of a loan, after which they phase out—usually within three to five years.
Prepayment penalties are only charged on certain types of loans, but they’re always laid out in detail in loan documents—which is why it’s important to read disclosures before taking a loan offer.
Prepayment penalties typically start out at around 2% of the outstanding balance if you repay your loan during the first year. Some loans have higher penalties, but many loan types are limited to 2% as a maximum. Penalties then decline for each subsequent year of a loan until they reach zero.
When prepayment penalties are assessed, it’s usually on the outstanding balance at the time the loan is paid back early.
Many prepayment clauses also include provisions for borrowers to pay off up to a certain percentage of their mortgage (20% is typical) without encountering a fee. So, if you want to make extra payments in the early years of your loan without refinancing or paying it off completely, prepayment penalties may not be an issue.
Some lenders calculate prepayment penalties differently. For example, some lenders charge fees equal to a certain number of months of interest, rather than the outstanding loan balance. But, regardless of how these fees are structured, they must always be listed in a loan agreement in order to be enforceable.
Let’s say there’s a new homeowner, Susan, who just bought her first house. To afford her purchase, she took out a 30-year mortgage for $400,000 at 4% that includes a prepayment clause. The clause calls for early payment fees on a sliding scale over the first five years of her loan.
Now, two years after taking her loan, Susan’s credit score has improved, interest rates have fallen and she wants to take advantage and refinance the $385,000 remaining on her loan. She finds another mortgage lender who will refinance her new loan for 15 years at 3.25%. All told, refinancing will save her $325 per month, but first, she’ll have to pay a prepayment penalty of $5,775 (or 1.5% of her outstanding loan balance) when she pays off her current loan.
In this scenario, Susan would recoup her penalty in a little over two years (once closing costs are added in) through savings from her new loan. If she plans to keep her house for at least three or four years, then refinancing and paying the penalty may make sense. If she thinks she may move in the next year or two, then she may just want to stick with her original loan.
If you want to avoid prepayment penalties on your next mortgage loan, there are certain lenders to avoid. These include alternative lenders (these are typically online, non-bank lenders), lenders that specialize in subprime loans and those that promise fast funding.
There are also loan products that you should stay away from in order to avoid getting hit with these fees. For example, it’s best to stay away from alternative loan products and instead stick to loans that you can get anywhere. That way, you’ll be in a better position to negotiate away prepayment penalties if your lender tries to include them.
Another thing you can do to avoid prepayment penalties is to avoid frequent refinancing, as it signals to your lender that you’re more likely to refi as soon as rates fall. You could also try to find a co-signer or offer a higher down payment in exchange for a better loan term (including the elimination of a prepayment fee).
Lastly, if you want to avoid prepayment penalties, you could just wait until prepayment penalties have phased out before paying off or refinancing your loan. Or, you can make allowable extra payments that are under the limit for how much of your mortgage you can pay back each year without triggering early payoff fees.
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