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 paid down or paid off 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

Prepayment penalties are written into mortgage contracts by lenders 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.