What is a 'Prepayment Penalty'

A prepayment penalty is a clause in a mortgage contract stating that a penalty will be assessed if the mortgage is prepaid within a certain time period. The penalty is based on a percentage of the remaining mortgage balance or a certain number of months' worth of interest. A 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 called a "soft" prepayment penalty.

BREAKING DOWN 'Prepayment Penalty'

Lenders write prepayment penalties into mortgage contracts to compensate for prepayment risk. As the incentive for a borrower to refinance a subprime mortgage is high, many subprime mortgages include prepayment penalties.

Prepayment penalties are included in mortgage contracts to protect the lender against the financial loss of paid interest over time. Such penalties are becoming less frequent in mortgage transactions, but they are still used in some instances. Adding a prepayment penalty to a mortgage may be done to safeguard against early refinancing or a home sale within the first two to five years after closing on a mortgage when a borrower is considered a risk to the lender. Alternatively, prepayment penalties are 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.

Prepayment Penalties in Practice

Prepayment penalties vary greatly among lenders, which is why borrowers should be diligent about asking for and fully understanding the prepayment disclosure document prior to closing. Prepayment penalties may be set as a fixed amount or a percentage of the remaining mortgage balance, and they may 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 years, while others charge a fee when the balance is paid off within the first five years. For example, a homeowner who decides to refinance his two-year-old mortgage with a remaining balance of $250,000 that has a prepayment penalty of 4% 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 as they can substantially increase the cost of refinancing a mortgage or selling a home.

  1. Prepayment Privilege

    The right given to a debt holder to pay all or part of a debt ...
  2. Prepayment

    The satisfaction of a debt or installment payment before its ...
  3. Single Monthly Mortality - SMM

    In mortgage-backed securities (MBSs), this is the percentage ...
  4. Prepayment Model

    A model used to estimate the level of prepayments on a loan portfolio ...
  5. Constant Percent Prepayment

    Annualized estimate of mortgage loan prepayments, computed by ...
  6. Refinancing Risk

    1. The risk that an early unscheduled repayment of principal ...
Related Articles
  1. Investing

    The Risks Of Mortgage-Backed Securities

    Find out how weighted average life guards against prepayment risk.
  2. Investing

    Subprime Is Often Subpar

    Proceed with caution when considering these short-term, high-interest mortgages.
  3. Personal Finance

    7 Steps to Help Pay off Your Mortgage in Retirement

    A monthly mortgage payment can be hard to handle in retirement if you're not ready.
  4. Personal Finance

    Finding the Best Mortgage Rates in 2017

    As home-buying technology has progressed, the process of finding the best mortgages rates can all be done online. Here's how:
  5. Personal Finance

    All-Time Low Mortgage Rates: Time To Refinance?

    Interest rates keep dipping lower and lower. Find out what it takes to tip the scales toward a refinance.
  6. Personal Finance

    Best 3 Mortgage Calculator Websites for Canadian Residents

    Here's an overview of the key features of Canadian mortgages, and a few of the best online mortgage calculators for Canadian home loans.
  7. Personal Finance

    Top 10 Common Mortgage Scams To Avoid

    How do you know which companies to avoid? Look for these telltale signs.
  8. Personal Finance

    Behind the Scenes of Your Mortgage

    Four major players slice and dice your mortgage in the secondary market.
  9. Personal Finance

    The Benefits of Mortgage Repayment

    Buying a home may be the biggest debt you'll ever incur. Learn why you should retire it sooner, rather than later.
  1. Do FHA Loans Have Prepayment Penalties?

    Learn whether FHA loans have prepayment penalties, and find out the rules governing interest charges when prepaying your ... Read Answer >>
  2. I made involuntary contributions to a retirement plan while temporarily employed. ...

    Your options depend on the type of penalty that would apply. If the penalty is a surrender charge or another penalty that ... Read Answer >>
Trading Center