Article Excerpt
Paying a loan off early is an impressive accomplishment, but it could come at a cost. Learn about prepayment penalties and when they might apply to you.
The idea of a mortgage is fairly straightforward. A lender loans you money to buy a home, and you pay the lender back over time with interest. The interest payments are a sort of rental fee you pay to use the lender’s money.
Borrowing money from a mortgage lender or bank is not the same as borrowing money from a friend or family member. When you borrow money from someone you know, they might worry about how long it will take you to pay them back. Lending money is not something they normally do. For lenders, however, it’s their entire business. The more money they lend, the more money they make through interest payments. As a result, some lenders would rather you didn’t pay them back early. They may charge a “prepayment penalty” to discourage you from doing so.
These days, prepayment penalties are rare in mortgage loans, and federal law sets strict limits on them. It is still a good idea to understand how they work. It should be noted that mortgages from Fairway Independent Mortgage Corporation (that includes us!) do not come with prepayment penalties.
What are prepayment penalties?
Some lenders charge a fee known as a prepayment penalty when a borrower pays off some or all of their mortgage before it is due (also known as the full “maturity date”). It might seem counterintuitive that a lender would not want to get their money back sooner, but if you look at it from the lender’s point of view, it makes sense. A prepayment penalty compensates the lender for the loss of future interest income from the loan that you would have paid if you kept paying through the original maturity date.
Lenders who charge prepayment penalties are not trying to stop any and all extra payments. You might decide to pay more than you owe on your mortgage bill each month to shorten the loan term. Prepayment penalties don’t usually kick in unless you try to pay a substantial percentage of the remaining balance or pay it off entirely.
A “hard” prepayment penalty applies any time a borrower tries to pay off the mortgage in advance. This includes when they are selling the home and a due-on-sale clause requires them to pay the balance. A “soft” prepayment penalty might make an exception for required prepayments. It only applies when a borrower chooses to pay the loan off early. Lenders must disclose any prepayment penalties to the borrower during closing.
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Why do some lenders charge prepayment penalties?
Mortgage lenders, like any other business, need to make money in order to stay open. Their profits come from interest paid by borrowers. When a borrower repays their loan, the lender loses a revenue stream.
Borrowing money from a mortgage lender is not like borrowing from a friend or family member. An individual might need the money back in the near future. Mortgage lenders operate differently. They have incentives to keep money circulating in the real estate market. They can get money to make more loans from banks, or from selling conventional mortgages to Fannie Mae or Freddie Mac. They are not in a hurry to get their money back from their existing borrowers. Their business models account for the 15- or 30-year terms of those loans. That’s how much interest income they are expecting.
How much are prepayment penalties?
A loan contract could set a prepayment penalty as a flat fee or a percentage of the remaining balance on the loan. The amount could depend on the age of the loan. For example, a lender might charge a 2% prepayment penalty if you pay off the loan during the first two years, followed by a 1% fee during the third year.
Are prepayment penalties legal?
Federal law sets strict limits for prepayment penalties in residential mortgage loans. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which became law in 2010, imposes numerous requirements on mortgage lenders and mortgage loan servicers. It puts the Consumer Financial Protection Bureau (CFPB) in charge of setting rules for prepayment penalties. The CFPB’s rules took effect on January 1, 2014, which means they do not apply to loans from before that date.
Government-backed mortgages, including FHA, VA, and USDA loans, may not have prepayment penalties. Generally speaking, only conventional mortgage loans that meet the following criteria may have prepayment penalties:
They have fixed interest rates.
They meet the “qualifed mortgage” standards set by Dodd-Frank, which relate to risks faced by borrowers.
They do not meet the CFPB’s definition of a “higher-priced mortgage.”
The CFPB also sets limits on the amount and duration of prepayment penalties:
A lender may only charge a penalty during the first three years of the loan term.
During the first two years, the amount of the penalty cannot exceed 2% of the outstanding balance. This decreases to 1% during the third year.
Additional requirements include the following:
If a lender offers a loan with a prepayment penalty, it must also offer an alternate loan option without the penalty.
The lender must provide information about the penalty to borrowers in billing statements, coupon books, and other notices.
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Are prepayment penalties enforceable?
A prepayment penalty is part of the loan contract between the lender and the borrower. The borrower must read and understand the contract when they sign it. The penalty must satisfy all of the CFPB rules discussed above. As long as both of those conditions are met, the prepayment penalty is likely to be enforceable.
Can I avoid a prepayment penalty? If so, how?
Few mortgage loans have prepayment penalties anymore. Those that do have strict limits because of the CFPB. If a lender presents you with a loan that includes prepayment penalties, they must offer an alternative loan as well. You may try to negotiate with them further to lower or remove the penalty.
Work with an upfront lender that cares!
A mortgage prepayment penalty may seem like a fine-print, hidden trick to catch you off guard. While it shouldn’t be this way (and normally isn’t), prepayment penalties aren’t advantageous to you as a borrower.
You should expect complete clarity and upfront information on the costs of taking a mortgage. The Wood Group of Fairway promises exactly what you’d expect: an honest, transparent, and personal mortgage experience with loan officers that actually care!
See which loan options fit you best with our easy online questionnaire. Then we’ll reach out and help you get started.
