Designed for low-to-moderate income borrowers, FHA loans require a lower minimum down payments and credit scores than many conventional loans.

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 types of 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 loan too quickly or choose to add additional principal payments.
  • These penalties protect lenders and investors of mortgage backed securities from prepayment risk. As a result, many subprime loans have such a penalty.
  • FHA loans, however, which are federally backed mortgages designed for low-to-moderate income borrowers, do not have any prepayment penalties.

What Is a Prepayment Penalty?

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, or it can 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 over time, and for investors of mortgage-backed securities who would be subject to increased prepayment risk.

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 a prepayment penalty, but many homeowners felt 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.