Before you sign mortgage documents, read the fine print. Some home loans have prepayment penalties that can cost you extra money if you pay off your balance ahead of schedule.
What Are Soft and Hard Prepayment Penalties and When Do They Apply?
If you take out a mortgage with a soft prepayment penalty, you’ll be able to sell your house whenever you want, and you won’t be subject to a penalty. You will, however, have to pay a penalty if you refinance.
A mortgage with a hard prepayment penalty is more restrictive. You’ll have to pay a fee if you refinance your mortgage or sell the house before the loan is paid off.
Lenders have their own ways to calculate prepayment penalties. Fees can be several thousand dollars. When a mortgage has a prepayment penalty, the penalty usually only applies during the first few years of the repayment period.
If you make extra payments occasionally or pay a bit extra each month, you might not have to pay a fee. Lenders generally let borrowers pay off up to 20% of their loan balance each year without being subject to a penalty.
Why Do Some Loans Have Prepayment Penalties?
Mortgage lenders make money from interest payments. A lender expects a buyer to remain in a house and pay principal and interest for several years.
If the buyer pays off the loan early, the lender misses out on some of the money it could have earned from interest. A prepayment penalty discourages a borrower from paying off a mortgage early and helps a lender make money if a homeowner does decide to get out of a loan ahead of schedule.
Why Might Borrowers Choose Loans With Prepayment Penalties?
Mortgages with prepayment penalties can cost thousands of dollars extra for borrowers who pay them off early. To make loans with penalties more appealing to homebuyers, lenders generally charge lower interest rates.
Many borrowers don’t know what prepayment penalties are, or don’t realize that they’re getting a mortgage with a penalty. Lenders may not point that out or do a good job of explaining it.
Should You Get a Mortgage With a Prepayment Penalty?
Before you agree to a mortgage, carefully review the terms and figure out how much a prepayment penalty would cost if you had to pay one. If you have questions, contact the lender.
If you’re confident that you’ll stay in your house past the time when a prepayment penalty applies, it may be a good idea to choose a mortgage with a penalty, especially if it has a lower interest rate than other loan offers you’ve received. If you might want to refinance or sell your home soon after you buy it, you may be better off steering clear of loans with prepayment penalties, just in case.