Why Mortgage Lenders Charge Prepayment Penalties (and How to Avoid Them)
When you take out a mortgage to buy a home, you borrow a large sum of money from a lender that you agree to pay back over a long period of time, often 15 or 30 years, and the lender makes money from the interest you earn. repay the loan over these years. However, some lenders include a prepayment penalty clause that allows them to charge you a fee if you pay off all or part of your mortgage before the full term is due. If they sound nasty, that’s because they are, and they’re very important for anyone with a mortgage to know about.
What is a prepayment penalty and why does it exist?
A prepayment penalty is an additional charge that is usually a percentage of the remaining mortgage balance that you will owe the lender if you pay off your mortgage before it is due. This creates a barrier for you to pay off the loan faster than planned.
From the lender’s perspective, the prepayment penalty protects them from losing the interest income they expected to earn if you had repaid the loan over the full term. When you get a mortgage, the lender expects to earn interest income for 15 to 30 years. If you can afford to pay off the loan in 5-10 years, the lender won’t make as much of a profit. Prepayment penalties help lenders reduce the risk of borrowers refinancing and prepaying when interest rates fall. This ensures that they will still earn the minimum amount even if you pay off the loan early.
However, not all mortgages have prepayment penalties. More consumer-friendly lenders may choose not to include them to attract borrowers who want the option of early repayment without additional fees.
How to avoid prepayment penalties
The best way to avoid a prepayment penalty is to review the terms before taking out a mortgage and choose a lender that doesn’t charge it. Be sure to read the fine print carefully.
If you already have a mortgage with a prepayment penalty provision, find out what the specific terms are. Prepayment penalties are not permanent – they expire after a certain period of time, usually several years. The penalty may also have limitations, such as being charged only for a certain amount of early loan repayment each year.
By understanding exactly how the prepayment penalty works, you can plan accordingly. You may be able to make additional principal payments up to the limit each year to pay off the balance faster without triggering the initial full penalty. And once the fine expires, you can consider options for full prepayment without additional fees.
While prepayment penalties can be an unwelcome surprise, doing your research beforehand and understanding what you’re agreeing to can help you avoid them when possible or reduce costs if you do have to pay them.