Why Mortgage Borrowers Will Want to Avoid the Prepayment Penalty If You Plan to Move or Refinance

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If you’re shopping for a home right now, surely you’ve heard the news: Interest rates are up, and they’re only expected to go higher.

That limits a homeowner’s buying potential, and it means you want to keep other costs to an absolute minimum. Here’s one you may not have even heard of: A mortgage prepayment penalty. It’s a fee that some mortgage lenders charge, and you might want to try to avoid.

Here’s everything you need to know about these penalties, and how to work around them.

What Is a Prepayment Penalty and How Does it Work?

“A mortgage prepayment penalty is a fee that some lenders are going to charge when you pay all or part of your mortgage loan off early,” said Michelle Petrowski, a certified financial planner in Phoenix. “This is really to ensure they don’t lose all the interest they were expecting to get.” 

This often happens when a borrower takes out a mortgage, only to sell the home and pay it off within a couple of years. The simple reason behind the penalty is that a lender puts in a lot of legwork to originate a mortgage, and they want to recoup that cost in the form of interest — something that wouldn’t happen if you paid off your entire mortgage early.

Each lender will have different policies about how and when prepayment penalties apply. And it typically doesn’t kick in if you make an extra payment here or there. But if you pay off the entire loan, or a large chunk of it, early, the lender would charge you an extra fee.

Which Loans Have Prepayment Penalty Fees?

Not all loans are created equal. Whether a loan has prepayment fees has a lot to do with what type of mortgage it is, and who the lender is. Here’s how to know the difference:

Loans that don’t have prepayment penalties

There are certain types of loans that never have prepayment penalties: FHA loans, VA loans, or USDA loans. In other words: Government-backed mortgages are not allowed to charge prepayment penalties.

Loans that could have prepayment penalties

Most other loan types are eligible for prepayment penalties. Again, it depends on the lender and your specific situation, but conventional loans and especially investment loans could have prepayment penalties attached. 

“They’re not uncommon,” Petrowski said, so be sure to read the fine print. If you’re not sure, ask your lender. Federal law states mortgage lenders are legally required to disclose penalty fees to you.

Pro Tip

Sometimes prepayment penalties come in exchange for a lower interest rate — which could be beneficial to you as the borrower.

The Dodd-Frank Act and the Consumer Protection Act was established in 2013 in order to build upon existing consumer protection regulations such as Regulation Z to limit when and what loan types prepayment penalties could apply. .  

How Much Do Prepayment Penalties Cost?

If you find out your loan does have prepayment costs, there are a few different ways they could work. “They can actually charge them in a variety of ways,” Petrowski said. 

Here’s how each one plays out:

Percentage of Principal

This is when your lender would simply charge a prepayment penalty as a flat percentage of the remaining principal balance on your loan. For example, if your outstanding balance was $200,000, and the lender charged a flat percentage of 2%, you would owe $4,000 in prepayment penalties.

Sliding Scale

This is a variation on the percentage-type prepayment penalty charge. Basically, the penalty would start off at a certain percentage — let’s say 2% — and then drop off in intervals as your mortgage ages. It might be a 2% penalty if you pay off the loan in the first year, then a 1% penalty in the second year, and so on until the penalty disappears. “As time goes on, the prepayment penalty changes,” said Tabitha Mazzara, director of operations at MBANC, a mortgage lending company headquartered in California.

Fixed Amount

A lender might also set a flat prepayment penalty amount upfront — say 2% of the original loan amount — and that penalty would remain the same for the entire period. For example, on a $300,000 loan, the fixed penalty would be $6,000 if you paid off the mortgage at any time in the first few years.

Why Do Lenders Charge Prepayment Penalties?

“A prepayment penalty is in place to protect the lender,” Mazzara said. 

Lenders want to be sure they make a certain amount of money from each mortgage to break even. This usually happens as they collect interest over the course of the loan. But if you pay it off early without contributing much interest, the prepayment penalties serve as a way to make up the difference.

“[Lenders are] hiring loan origination people, there are underwriters, they’re checking credit reports,” Petrowski said. All of that takes time and money, so the purpose of the prepayment fee is to compensate the lender for the resources that went into the mortgage in the first place.

Should You Take or Avoid a Loan With a Prepayment Penalty Fee?

Whether you need to avoid prepayment penalties really comes down to what you plan to do with your home.

Petrowski said that if a borrower is shopping for their forever home, with no intention to sell or pay off the loan early, there’s no harm in accepting prepayment fees because they’ll never end up paying them. Plus, accepting prepayment fees sometimes comes in exchange for a lower interest rate, according to Mazzara. 

That said, if you plan to move in the near future, or you know you’ll want to refinance quickly, you would want to avoid these penalties by finding a lender who doesn’t charge them, both experts recommend.

Either way, when you’re talking to a lender, you’ll want to make sure you understand what the penalties would or wouldn’t be, and pencil out various scenarios to see which makes the most sense for you.

“That’s where the fine print in those loan estimates reality becomes important,” Petrowski said.

See NextAdvisor’s library of mortgage lender reviews to see which lender charges prepayment penalties, and which do not.