Below we outline how to determine if your mortgage has a prepayment penalty. Although these fees are relatively uncommon, no one wants to pay money to their lender if they payoff their loan early. Continue reading to understand how prepayment penalties work and more importantly, how to avoid them in the first place.
Learn What a Prepayment Penalty Is
A prepayment penalty is a fee charged by a lender if a borrower repays a mortgage before a specified period of time, usually within the first three to five years of the loan. In short, the lender wants to collect interest on your loan as long as possible so they incentivize you to not pay off your mortgage early by penalizing you if you do.
The prepayment penalty may be charged as a percentage of the mortgage amount or as a flat fee. In some cases the amount of the penalty decreases, depending on when the mortgage is repaid. For some loans, the prepayment penalty is triggered if you pay off your mortgage in full while in other cases paying off a significant portion of your loan balance triggers the charge.
Review Your Mortgage Documents
If you already have a mortgage, the best way to determine if your loan has a prepayment penalty is to review your mortgage note, which is the document outlines the key terms and features of your loan. The mortgage note indicates if you incur a prepayment penalty if you payoff your mortgage early.
Review an Example Mortgage Note
For a standard mortgage note, the prepayment penalty clause is typically found on the first page under "Borrower's Right to Repay." If your note does not have this clause then you are in the clear and you can pay off your mortgage at any time without paying an extra fee.
Mortgage Industry Guidelines for Prepayment Penalties
The positive news is that prepayment penalties are not allowed for most mortgages. Following the real estate market collapse in 2008, the government imposed new regulations to discourage these penalties.
Specifically, Fannie Mae and Freddie Mac guidelines do not permit prepayment penalties. Fannie Mae and Freddie Mac are government sponsored entities (GSEs) that set eligibility and qualification requirements for the mortgage industry. Although Fannie Mae and Freddie Mac do not lend directly to borrowers, the vast majority of traditional lenders such as banks, mortgage brokers, mortgage banks and credit unions implement the rules they set.
Learn How to Avoid Prepayment Penalties
Given the industry guidelines, prepayment penalties for mortgages are relatively uncommon and you should avoid any loan that charges one. If you are applying for a mortgage and you want to determine if the loan includes a prepayment penalty, you should review the Loan Estimate provided by the lender.
According to lending laws, the lender is required to provide you a Loan Estimate that outlines key mortgage terms within three days of applying for the loan, so at the beginning of the mortgage process. The Loan Estimate indicates if a mortgage has a prepayment penalty in the "Loan Terms" section at the top of page one.
Review How to Use a Mortgage Loan Estimate
We recommend that you take the time to carefully review the Loan Estimate and other loan documents to ensure that you mortgage does not include a prepayment penalty. If you discover that the lender is attempting to charge you a prepayment penalty, we recommend that you cancel the mortgage and switch lenders.
For a home purchase mortgage, you can cancel, or rescind, your mortgage at any time before you sign your loan documents. For a refinance, you can cancel your mortgage up to three days after you sign your loan documents, although we recommend that you not sign the documents if you find a prepayment penalty clause.
Know the Lenders that Are Allowed to Charge Prepayment Penalties
It is important to highlight that although mortgage prepayment penalties are highly unusual, they are not illegal. Non-traditional, hard money lenders, also known as private money lenders, do not follow traditional mortgage industry guidelines and are allowed to charge prepayment penalties.
You typically only use a hard money lender if you cannot qualify for a mortgage with a traditional lender. These lenders usually charge much higher interest rates and closing costs and may also include additional fees that are not permitted with a standard mortgage. If you decide to apply for a hard money loan be sure to understand if your mortgage includes a prepayment penalty.
“What is a prepayment penalty?” CFPB. Consumer Financial Protection Bureau, September 25 2017. Web.