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Prepayment penalty on a mortgage: Costs, examples, and tips for avoiding the fee

Yahoo Personal Finance· Getty Images
Hal Bundrick
4 min read

Paying off a debt early should earn you extra points, right? Perhaps a hearty "thanks!" and a discount on your next home loan. If only. Actually, paying off a mortgage early might result in a fee called a prepayment penalty — especially if you repay the loan within the first few years.

Here's how that works.

In this article:

A prepayment penalty is a fee some mortgage lenders charge when a borrower pays off all or a substantial part of their mortgage before the term ends. Not all home loans or lenders charge a prepayment penalty. If a lender does, it will be clearly stated in your mortgage loan agreement, billing statement, payment coupon book, or any notice of an interest rate adjustment.

Prepayment penalties do not apply to smaller extra payments that you may add to regular installments to reduce the principal balance — only to larger sums dedicated to reducing the debt, usually over 20% annually.

Dig deeper: Should you make one extra mortgage payment per year?

There are two types of prepayment penalties:

  1. Soft prepayment penalty. Homeowners can sell a home without an extra fee, however, a penalty would apply they refinance or pay off the mortgage.

  2. Hard prepayment penalty. A fee applies in all three scenarios: selling, refinancing, or paying off the mortgage.

Learn more: 6 times when it makes sense to refinance your mortgage

The most common fees are a percentage of the remaining loan balance or a predetermined number of months of interest.

Regarding a fee based on the loan balance percentage, prepayment penalties are typically 1% to 2% of the remaining mortgage balance. In many cases, the first year of the loan term will have a higher fee. As you near the end of the penalty period, the charge will likely be lower.

A prepayment penalty may also be a predetermined flat fee, though that is less common.

Read more: How much does it cost to sell your home?

Using a $200,000 home loan balance, mortgage prepayment penalties may be calculated as follows.

For 1% of the remaining loan amount:

  • $200,000 X 0.01 = $2,000 lump-sum prepayment penalty

For six months of interest on a 6% mortgage interest loan:

  • To calculate annual interest on a 6% mortgage: $200,000 X 0.06 = $12,000

    • To determine the monthly interest: $12,000 / 12 = $1,000

    • To determine six months of interest: $1,000 X 6 = $6,000 prepayment penalty amount

Government-backed loan types don't have prepayment penalties. So, if you have a VA mortgage, FHA loan, or USDA loan, you shouldn't have to worry about a prepayment penalty clause.

Overall, prepayment penalties are less common than before the 2010 Dodd-Frank Act, which established consumer protection laws following the 2008 financial crisis.

For loans with a prepayment penalty, you may be able to avoid the charge if you wait long enough. Prepayment penalties are usually applicable, if at all, only during the first three to five years of a mortgage loan.

Consult the Closing Disclosure given to you prior to closing — or your actual mortgage document — to determine if your loan has a prepayment penalty. If it does, you will want to consider how that fee will impact the proceeds you receive from any sale or refinance.

However, the best way to avoid a prepayment penalty is before you close on a new mortgage by choosing a lender or type of mortgage that doesn't charge such a fee. If you see a prepayment penalty on the official Loan Estimate that a lender must give you before you make a mortgage decision, ask if it can be removed — or shop for another mortgage lender.

Prepayment penalties are not allowed in some states. Check with your lender or a real estate attorney in your state to find out if prepayment penalties are permitted where you live.

Lenders may charge a prepayment penalty when you pay off a loan early because you're actually ending an income stream of interest that they've been counting on. The fee is an effort to discourage you from substantially paying down, or paying off, the loan and eliminating that lender's interest income.

If you’ve had your mortgage for at least three years, it's likely that you’re no longer at risk of a prepayment penalty (if there was one included at closing in the first place). However, to make sure, check your loan documentation or contact the originating lender to confirm.

This article was edited by Laura Grace Tarpley.