The Home Loan Prepayment Penalty

This post will cover the nature of a prepayment penalty in how it relates to your home loan. What is it? Why do I consider it a negative thing? How do I know if I have one? Why do lenders offer prepayment penalties? What can be done to avert it?


First, what is a prepayment penalty?

A prepayment penalty is simply a 'penalty for paying your home loan off before an agreed time'. For instance, subprime loans, which most of you have heard of, come with prepayment penalties. What this means is that you typically aren't able to sell or refinance your home loan until 2-3 (in some cases, 5) years have passed. Considering that the statistical average for people paying off their home loan is 36 months, that's a tough rule to abide by.

There is a 'soft' prepayment penalty. This applies if you refinance only.
There is also another penalty, called a 'hard' prepayment penalty. This applies if you sell or refinance. Be sure which one you have.


Why do I consider a prepayment penalty a negative aspect of a home loan?

For instance, I bought a home on a 2 year fixed, subprime ARM back in 4/2006. I did my own loan, and knew it was a 2 year fixed...it was the only thing my 600 credit score could get, so the benefit outweighed the cost. My loan came with a 2 year prepayment penalty. This means that I couldn't sell or refinance within 2 years without having to pay "6 months' interest". Well, if my loan is 220,000 and the interest rate is 6.6%, then 6 months interest = $7260. WHEW! Yes, that's right: $7260. (As you're now figuring out, this is another potential hidden fee the banks place on certain loans). Let's just say I'm definitely not touching the loan until 4/08.

For obvious reasons above, I'm sure you now understand why a prepayment penalty is not a desirable thing. Some lenders will say, "You can always buy out of it!". Yeah, sure, for a 1-1.5% increase in interest rate! That isn't desirable.

However, in certain cases, a loan with a prepayment penalty is the only way you might get a home loan. The cost-benefit analysis needs to be employed; pros and cons both need to be weighed.


How do I know if I have a prepayment penalty?

Get a Truth in Lending Document from your broker/banker. There is a box near the bottom of the form, that says "You May/Will Not have to pay a penalty". You would want the "Will Not" section checkmarked.


Why do lenders offer Prepayment Penalties?

This is a more difficult question. There's no one answer. Lenders, when they fund your loan, package the loan and sell it to investors. These investors expect the loan to be performing for a certain numbers of years (3 years or so), and so the funding lender will put a prepayment penalty on the loan in order to guarantee a certain amount of income from this loan. If the borrower refinances early, then the income comes from the penalty; if the borrower keeps the loan for the specitfied period of time, then the lender gets the income from the monthly payments. Sometimes, lenders will put a prepayment penalty on the loan when the funding lender pays a 'rebate' to the broker. This is especially the case with the negative amortization/ negative interest/ Pay Option Loans (the 1% loans). I could go into this further, but suffice it to say that the prepayment penalty here is the amount of commissions your broker got when he first originated the loan....chew on that awhile.


What can be done to avert a prepayment penalty?

Trust your lender.
More specifically, try to get a Full Documentation of Income loan, where you prove your income. Some brokers/bankers will do a Stated Income loan just because it is easier and requires less documentation. Now, for those of you who are Self-Employed, like myself, and who's tax returns look like a foreign language Do-It-Yourself Handguide, Stated Income may be your only option. But, unless you write off everything under the sun, a good mortgage broker should be able to use your Tax Returns. However, there are still some very restrictive guidelines out there, and Stated Income may be the only way to go; just make sure there's no prepayment penalty. You may even have to switch loans (say from a 5/1 ARM Interest Only to a 30 year fixed full amortization).

Ultimately, though....you've got to Trust Your Lender. That's the real bottom line.