Mortgage Pre-Payment Penalties Explained
Pre-payment penalty. The term scares most mortgage borrowers. And yet the pre-payment penalty can actually be a great way to lower or eliminate your closing costs. But what is a pre-payment penalty? A pre-payment penalty is a monetary penalty for paying off your loan early. A lender will increase the payoff amount on your loan depending on when you payoff your loan. For example, lets say you refinance your existing loan in April and sell your home the following April. At closing, you may have to pay an additional six months worth of interest in order to payoff the mortgage and effect a transfer of title.
Lenders charge pre-payment penalties to ensure their investment. When a lender agrees to give you a mortgage, they have overhead costs associated with writing that loan. These include their buildings, their office supplies, and probably most costly, their staff of underwriters, funders, and more. In order to recoup these costs, they need to hold their loans for a minimum amount of time, or charge a penalty.
Penalties typically accompany adjustable rate mortgages. But some fixed rate loans have them too. The amount of the penalty and the length of the penalty vary by lender. But typically a penalty amounts to about six months worth of interest. And typically the penalty affects you for the first one, two or three years of your loan. There are also soft and hard pre-payment penalties. A soft penalty only affects you when you refinance your loan. So if you payoff your loan by selling your home, you are not required to pay the penalty. In contrast, a hard penalty affects you when you payoff the loan for any reason within the penalty period.
In many cases, you and your loan officer may decide you want a pre-payment penalty. One determining factor is how long you plan to stay in your home. If you plan to stay in your home permanently, or for more than a few years, then you can usually use a pre-payment penalty as a bargaining chip to negotiate lower closing costs and a better rate or margin. This is especially true in the case of the popular option ARM. By accepting a pre-payment penalty you may be able to get a lower margin and even have your loan officer cover all of your closing costs.
There are a few instances when you should definitely not accept a pre-payment penalty. The first is if you expect to sell your home in the very near future. If you know that your job will require you to relocate in the near future, then of course, you will want to make sure that you don’t have a pre-payment penalty. Second, if you plan to pay off the loan within a few years time, you should probably avoid a pre-payment penalty.
Overall, the most important thing to remember is that a pre-payment penalty can be a wise choice if you use it as a bargaining tool. Also, make sure you know the terms and conditions of your pre-payment penalty before you sign your loan documents. At signing make sure you carefully read your note and the section regarding your pre-payment penalty. This is usually found in an addendum to your note towards the back. A pre-payment penalty may make sense for you, but carefully evaluate your situation first.
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