FHA loans were designed for low and moderate income borrowers. They require lower minimum down payments and credit scores than many conventional loans require.

Unlike subprime mortgages issued by some conventional commercial lenders, Federal Housing Administration (FHA) loans do not have prepayment penalties. Rules governing FHA loans state that these mortgages cannot contain any unnecessary fees, such as a due-on-sale clause or prepayment penalty, that may cause financial hardship to borrowers.

Key Takeaways

  • Some traditional mortgage loans carry a prepayment penalty that is assessed if borrowers repay their loans too quickly or add additional principal payments.
  • These penalties protect lenders and investors in mortgage-backed securities from prepayment risk. As a result, many subprime loans have such a penalty.
  • FHA loans, which are federally backed mortgages designed for low and moderate income borrowers, do not have any prepayment penalties.
  • There are also indirect costs potentially associated with prepaying loans, including loss of tax deductions, lower liquidity, and missed opportunities to invest in stocks.

What Is a Prepayment Penalty?

A prepayment penalty is specified in a clause in a mortgage contract stating that a penalty will be assessed if the borrower significantly pays down or pays off the mortgage before term, usually within the first five years of committing to the loan. The penalty is sometimes based on a percentage of the remaining mortgage balance. It can also be a certain number of months' worth of interest.

Prepayment penalties protect the lender against the financial loss of the anticipated interest income that would otherwise have been paid. They also reduce prepayment risk when investing in mortgage-backed securities.

How Mortgage Interest Is Calculated in Case of Prepayment

For all FHA loans closed before Jan. 21, 2015, while you are not required to pay extra fees when paying your FHA loan early, you are still responsible for the full interest as of the next installment due date. For example, assume the monthly payment due date of your FHA loan is on the fifth of every month. If you made your monthly payment by the first of the month, you are still liable for the interest until the fifth.

Even if you paid the full balance of your mortgage, you are still responsible for the interest until the payment due date.

This post-payment interest charge was not technically a prepayment penalty, but many homeowners felt like it was. In 2012, holders of FHA loans paid an estimated $449 million in post-payment interest charges. To reduce the burden on homeowners, the FHA revised its policies to eliminate post-payment interest charges for FHA loans closed on or after Jan. 21, 2015. Under these policies, lenders of qualifying FHA loans must calculate monthly interest using the actual unpaid mortgage balance as of the date the prepayment is received.

Issuers of FHA loans can only charge interest through the date the mortgage is paid.

Other Costs of Prepayment

Although there are no direct penalties for paying off FHA loans early, there are indirect costs. At first glance, it seems like losing the mortgage interest tax deduction could be a negative side effect of prepaying an FHA loan. When people using that tax deduction pay off their mortgages early, they no longer get to deduct the interest expense on their taxes. However, the Tax Cuts and Jobs Act (TCJA) increased the standard deduction so much that many taxpayers no longer itemize deductions. That means that a lot of borrowers with mortgages are not using the mortgage interest tax deduction in the first place.

More subtly, prepaying FHA loans causes borrowers to lose liquidity. Homeowners who put extra cash into their FHA loans will have trouble getting it back out if they need it later. A home equity line of credit (HELOC) is often the best way to get cash out of a home. However, the FHA does not provide home equity lines of credit, so borrowers will have to look elsewhere. Furthermore, lenders might raise credit score requirements for HELOCs, as they did during the coronavirus crisis.

Be sure that you have sufficient cash reserves before prepaying an FHA loan. Having enough cash to cover expenses for a few months or even a year is generally a good idea.

Finally, there is also an opportunity cost to prepaying an FHA loan. By paying down the loan, homeowners miss out on the money they could have made investing in other assets.

Interest on home loans is usually lower than the expected long-term return of stocks, real estate, and many other assets. In particular, real estate investment trust exchange traded funds (REIT ETFs) give investors an easy way to tap into real estate's full returns. Furthermore, homeowners can sell REIT ETFs quickly when they need cash. However, REIT ETF prices are likely to be lower during an economic downturn.