What Is a Loan Prepayment Penalty? | Mortgages

Millions of homeowners use a mortgage to secure their piece of the American dream. But some home loans come with costly prepayment penalties that can kick in if you pay off the loan prematurely.

These prepayment penalties can cost homeowners thousands of dollars if they pay off their mortgage entirely, refinance their loan or sell their home.

“If possible, I would try to avoid a loan with prepayment penalties,” says David Haas, a New Jersey-based certified financial advisor with Cereus Financial Advisors. “It reduces your flexibility.” 

A prepayment penalty is the fee a lender may charge when you pay off a home loan early. In most cases, the fee only applies if you pay off the entire mortgage balance, and do so within a specific period – often the first three years of the loan.

Prepayment penalties can apply when you:

Lenders like prepayment penalties because they encourage borrowers to pay off loans slowly – which allows the lender to collect more interest over a longer period.

Not every mortgage has a prepayment penalty. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act added new requirements for mortgage lenders and servicers, including stricter guidelines regarding prepayment penalties.

In addition to federal rules, many states have laws that limit the potential impact of prepayment penalties. For example, lenders may be prohibited from charging large fees, or there may be regulations limiting the time period for which a prepayment penalty can apply. Some states prohibit them entirely.

“Prepayment penalties have never been legal on residential mortgages in New Jersey,” Haas says.

But if your loan has a prepayment penalty and you undertake an action that triggers the penalty, you could be subject to hefty fees.

Typically, a prepayment penalty only applies if you pay off the entire mortgage balance within a specified period, which can vary from lender to lender.

Some lenders may also charge a penalty if you pay down a large amount of your mortgage, even if you do not pay it off entirely. For instance, if you pay off more than 20% of your loan in a given year, the lender might hit you with a prepayment penalty.

Because the rules differ by lender, it is crucial that you carefully read the terms of your loan agreement so you know exactly how much you might owe and the specific circumstances that would trigger a prepayment penalty.

By law, lenders must disclose the existence of any prepayment penalties in your loan documents. In many cases, this information can be found in a section marked with the title “addendum to the note.”

You can also ask the lender to show you where to find the information in your loan paperwork.

There are two major types of prepayment penalties:

How much you pay in prepayment penalties differs from lender to lender.

Some will charge you a penalty equivalent to a specific number of months in interest costs. For example, you might be charged the equivalent of six months of interest on your mortgage. It’s also possible that a lender will charge you a fixed dollar amount.

Perhaps you want to pay off your new mortgage so you enter retirement debt-free. This can be a smart way to shore up your finances as you begin your golden years.

Let’s say you decide to pay off the $300,000 balance in the second year of your loan. If your loan has a 1% prepayment penalty in the loan’s second year, your lender would likely hit you with a penalty fee of $3,000.

A prepayment penalty can cost you cash and deprive you of the flexibility to take advantage of new opportunities to lower your mortgage costs.

For example, if you have a mortgage with a high interest rate and rates later drop, a prepayment penalty might prevent you from refinancing unless you are willing to pay the fees associated with the penalty, Haas says.

“It ensures you have to pay those high rates, even if rates go down later and it may make more sense to refinance or pay off the balance,” he says.

Most borrowers prefer to avoid prepayment penalties. Fortunately, these penalties are becoming much less common, making it easier to find lenders that do not charge them. “The best way to avoid prepayment penalties is to either shop around lenders to find one that doesn’t have them, or to try negotiating the prepayment penalties before closing on the loan,” Haas says.

If you have a mortgage with a prepayment penalty, the best way to avoid triggering this cost is to clearly understand the terms of your loan agreement. Armed with this knowledge, you will know which activities to avoid that might put you at risk.

Because prepayment penalties are much less common today, fewer people need to worry about these fees. Paying off your mortgage early can save you thousands of dollars in interest costs attached to your home loan. In addition, being mortgage-free means you will no longer have a monthly payment.

“The benefit of paying off one’s mortgage early is that you’ll have the extra cash flow to enjoy, or to save and invest,” says Kevin O’Brien, a Massachusetts-based certified financial planner and founder and president of Peak Financial Services.

That makes paying down a home loan tempting for many.

However, there are potential drawbacks. If you devote tens of thousands – or even hundreds of thousands – of dollars to paying off your home loan, you will reduce your savings in the short term.

This lack of financial liquidity can pose a problem if you face a sudden money emergency, such as the loss of income from a job or the need to quickly make expensive home repairs.

In addition, paying down your mortgage might not provide you with a major financial benefit if you have a home loan with a low interest rate.

In recent years – right up through early 2022 – mortgage rates hovered near all-time lows. If you were fortunate enough to take out a loan during that period, it might make sense to steadily pay down your mortgage instead of paying it off all at once.

“If the rate is low and you can deduct the interest on your tax return, it may be better to save and invest at a higher rate elsewhere,” O’Brien says.

Some people wonder how paying off a mortgage will impact their credit score. But in truth, eliminating a home loan is unlikely to change your credit score much.

Experian notes that after you pay off the home loan, it will remain on your credit report for a decade as a closed account in good standing.

If you plan to pay off your mortgage, try to avoid prepayment penalties. If you must take a loan with a prepayment penalty, try to make sure it’s a short-term loan, Haas says.

“Prepayment penalties on a 15-year or 30-year loan is a terrible idea,” he says.