A prepayment penalty is a fee that is imposed if a mortgage is paid off or paid down by a certain percentage within a certain time frame in the life of that mortgage.
You may be wondering whether your current mortgage has one. Chances are that it does not. If your mortgage terms included a prepayment penalty, by law, you would have had to sign a disclosure stating that you were aware of the penalty and its terms.
Per the Dodd-Frank Act, effective July 21, 2010, prepayment penalties became illegal on most residential mortgages, so this is far less common than it used to be. However, certain types of mortgages may still have them.
The original purpose of the prepayment penalty was to protect the lender from people who frequently refinanced when rates fluctuated greatly in a short period of time. It’s also designed to protect the lender’s income. It is expensive for lenders if you either pay off or significantly pay down your loan early, since the income they earn from loans typically includes payment streams over time. This is especially true if they are servicing your loan (taking the payments, paying out the taxes, and paying insurance).
Still, in order to incur a penalty, buyers would usually have to pay off a significant portion of the loan very quickly. A typical example is to pay 20 percent of the loan in one year. On a $100,000 loan, this would require paying down $20,000 in 12 months. A homeowner paying even $1,000 per month extra on the principal would fall well short of reaching that point.
In other words, you’re probably free of any worries about prepayment penalties.