how a prepayment penalty works
prepayment penalties are written into mortgage contracts by lenders to compensate for prepayment risk particularly in difficult economic climates and under circumstances where the incentive for a borrower to refinance a subprime mortgage is high these penalties don t only kick in when a borrower pays off the entire loan some penalty provisions go into effect if the borrower pays a large portion of the loan balance in a single payment adding a prepayment penalty to a mortgage can safeguard against early refinancing or a home sale within the first three years after closing on a mortgage when a borrower is considered a risk to the lender alternatively prepayment penalties might be added as a way to recoup some profit when a mortgage is advertised with a lower than average interest rate mortgage lenders are required to disclose prepayment penalties at the time of closing on a new mortgage such penalties can t be imposed without a borrower s consent or knowledge 1 however borrowers should be made aware of any potential for prepayment penalties well before closing if the lender hasn t said anything about one borrowers should ask early on making small additional principal payments over the life of the loan does not normally trigger penalties but it can t hurt to ask your lender to make sure types of prepayment penaltiesa prepayment penalty that applies to both the sale of a home and a refinancing transaction is called a hard prepayment penalty a prepayment penalty that applies to refinancing only is referred to as a soft one limitations of prepayment penaltieswhile some home loans include prepayment penalties they are not legal on single family fha loans for other home loans lenders can only inflict prepayment penalties during the first three years with limits on the size of the penalty additionally the lenders have to offer a loan that does not include a prepayment penalty as an alternative these rules are in effect for loans issued after january 10 2014 established by the consumer financial protection bureau cfpb following the passage of the 2010 dodd frank act 2va mortgage loans issued to military and student loans do not allow prepayment penalties 3special considerationsprepayment penalties vary among lenders this means borrowers should be diligent about asking for and fully understanding the prepayment disclosure document prior to closing prepayment penalties can be set either as a fixed amount or as a percentage of the remaining mortgage balance they may also be assessed on a sliding scale based on the length of time the mortgage has been in place some lenders impose a penalty when a refinance or sale of the home is completed within the first two to three years of the original mortgage others charge a fee when the balance is paid off within the first five years example of a prepayment penaltya homeowner decides to refinance a two year old mortgage with a remaining balance of 250 000 if there is a prepayment penalty of 4 said homeowner would pay 10 000 to the original lender for paying off the mortgage early borrowers should be aware of the specifics of their lender s prepayment penalties they can substantially increase the cost of refinancing a mortgage or selling a home 