What Is a Prepayment Penalty?

A prepayment penalty is a clause in a mortgage contract stating that a penalty will be assessed against the borrower if she 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 interest that would otherwise have been paid over time.

How a Prepayment Penalty Works

Prepayment penalties are written into mortgage contracts by lenders to compensate for prepayment risk, particularly in difficult economic climates and under circumstances when the incentive for a borrower to refinance a subprime mortgage is high. These penalties don't only kick in when a borrower pays off the entire loan. Some penalty provisions go into effect if the borrower pays off a large portion of the loan balance all at once.

Adding a prepayment penalty to a mortgage can safeguard against early refinancing or a home sale within the first five years after closing on a mortgage when a borrower is considered a risk to the lender. Alternatively, prepayment penalties might be 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. Such penalties can't be imposed without your consent or knowledge. You should be made aware of any potential for prepayment penalties well before closing on your loan, but ask your lender about them before then if you're unsure.

[Important: Making small, additional principal payments over the life of the loan does not normally trigger penalties, but it can't hurt to ask your lender to make sure.]

Types of Prepayment Penalties

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 referred to as a "soft" prepayment penalty.

Key Takeaways

  • A prepayment penalty is a clause in a mortgage contract stating that a penalty will be assessed against the borrower if he significantly pays down or pays off the mortgage, usually within the first five years of the loan.
  • Prepayment penalties protect lenders against the financial loss of interest that would have been paid on the loan over time.
  • Mortgage lenders are required to disclose prepayment penalties at the time of closing on a new mortgage.

Special Considerations

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 can be set as a fixed amount or a percentage of the remaining mortgage balance, or 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 to three years, while others charge a fee when the balance is paid off within the first five years.

Example of a Prepayment Penalty

A homeowner decides to refinance his two-year-old mortgage with a remaining balance of $250,000. He would pay $10,000 to the original lender for paying off the mortgage early if he has a prepayment penalty of 4%. Borrowers should be aware of the specifics of their lender's prepayment penalties because they can substantially increase the cost of refinancing a mortgage or selling a home.