A prepayment penalty is a loan that is paid off before the actual time frame of the loan. These penalties typically are not very common anymore because most people do not pay off their loan before the loan time frame. However, if a loan has a prepayment penalty, the homeowner will agree to pay the lender a fee if the loan is paid off before five years of origination. In addition, most loans do not carry a prepayment penalty fee. These loans include:
These three loans are issued and insured by the government and can be paid back at any time as long as it is in the time frame of the loan.
Keep in mind, some homeowners will find out over the years that they have a prepayment penalty on their first or second mortgage. This happens because during the time of the home buying process, lenders and homeowners will look for the cheapest rate possible. Sometimes with a cheap interest rate, a prepayment penalty will be attached to the loan. Banks will typically lower an interest rate to 0.25% and require borrowers to pay a penalty if the mortgage is paid off too quickly. It is always important to ask this question of prepayment penalties before a loan is signed.
A prepayment penalty can range anywhere from 2-4% of the loan amount. A prepayment penalty will either be a fixed fee or a sliding scale depending on what loan the home owner has chosen, and which lender they are working with. The bank will want the home owner to hold onto the loan for the full duration of the loan time. The prepayment penalty fee on a sliding scale will be lower the longer the homeowner has the loan.
For the most part, it is not a bad idea to have a loan with a prepayment penalty. If the homeowner understands the loan and the way the penalty works of course. In some cases the homeowner will choose the have a loan with a prepayment penalty because the interest rates and closing cost will be cheaper in the end. For example, if a homeowner wants to refinance into a loan with a better rate, paying the prepayment penalty will often be the better bet. A homeowner who does this might have to hypothetically pay an amount of $3,000 for the penalty. However, the homeowner may save a total of $15,000 over a 10 year period. Also, a prepayment penalty could be worth paying if the homeowner wants to evade a fast approaching balloon payment.
Keep in mind, most lenders do not even have prepayment penalties attached to their loans anymore. Homeowners typically are free to refinance, sell, or pay off their home at any time without worrying about additional prepayment costs.