Prepayment Penalties and How to Avoid Them

Everyone wants a lower rate when they get a mortgage, but it shouldn’t come with hidden fees attached. One common hidden fee is a mortgage prepayment penalty. But what exactly is a prepayment penalty? How can you avoid one? What are some key dos and don’ts?

Fear not, this post holds the answers to all of these questions. Let’s get to it.

What Is the Prepayment Penalty?

A mortgage prepayment penalty, also called an early payoff penalty, is a fee that is charged if you pay off your principal balance early. It’s typically equal to a certain percentage of the overall unpaid principal balance at the time of the payoff. There are several disadvantages to this type of fee.

One of the ways anyone who gets a mortgage avoids paying a lot of interest on their loan is by making extra payments toward the principal over several years in order to pay off their mortgage early. In theory, this works because the lower your unpaid balance, the less overall interest you pay and the sooner you pay off the mortgage.

However, lenders and other mortgage investors make less money if you pay less interest. To get around this, they may give you a rate that looks extremely attractive and lower than others around, but it could come with a prepayment penalty for at least several years into the loan. This discourages you from paying off the loan early, lest you get hit with what could amount to tens of thousands of dollars in fees.

It’s important to note that since refinancing involves paying off your current loan, prepayment penalties discourage doing that as well. This could mean not being able to take advantage of lower rates if they drop or not being able to utilize your home equity to accomplish your goals like paying off credit cards, doing home improvements or boosting a college fund.

How Can I Avoid a Prepayment Penalty?

Now that you know what a prepayment penalty is, how can you avoid it? The simplest way to handle it is to find a lender who doesn’t charge a penalty.

Quicken Loans doesn’t charge prepayment penalties on any of its mortgages. It’s our policy and it’s the right thing to do for our clients.

When considering lenders, ask them about their policy regarding prepayment penalties. If they have one, does it last for a certain number of years or the entire term of the loan? What percentage of the loan does the penalty amount to?

It’s worth noting that certain states don’t allow lenders to charge prepayment penalties. However, even in these states, banks may be regulated by federal instead of state law, so be sure to always ask about the policies and do your research.

The Dos and Don’ts of Mortgage Prepayment Penalty Clauses

If you’re shopping for a mortgage, what are the do’s and don’ts when it comes to these clauses?

Do

There are a couple of things you should do if you’re shopping for a mortgage and you’re concerned about a prepayment clause.

Make sure you know which laws the lender is governed by. As mentioned above, for banks not under federal jurisdiction, state laws may prevent lenders from inserting prepayment clauses.

By familiarizing yourself with the policies of the lender, you can also find banks that don’t charge such penalties.

If there is a prepayment penalty, make sure to read the contract. Know the exact terms of any penalty and if it goes away after a number of years.

Don’t

If you have a loan with a prepayment penalty, don’t pay it off or attempt to refinance without first doing the math and seeing if doing so actually saves you any money after the penalty is applied.

Of course, the best thing is to make sure you don’t accept a penalty clause at all. The lack of prepayment penalties is just one of many benefits of having a loan with Quicken Loans.

Do you have any questions about how this works? Leave them for us in the comments below.

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