A prepayment penalty is a clause in a mortgage contract stating that a penalty will be applied if the borrower pays off or significantly pays down the mortgage before term, usually within the first three years of committing to the loan. Sometimes the penalty is a certain number of months’ worth of interest. Sometimes it is based on a percentage of the remaining mortgage.
Prepayment penalties were originally designed to protect the lender from people refinancing repeatedly when rates fluctuate. It is costly for lenders if you pay off or significantly reduce your mortgage balance. The income the lender makes is generally a payment stream over time, so if the loan is paid off early or reduced, this limits their income. This is especially true if the lender is also the servicer of the loan (who you make the payments to). 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.
Does your mortgage have a prepayment penalty? Most likely, it does not. After the mortgage reform bill (Dodd-Frank) in 2010, the penalties became illegal on most residential mortgages. Chances are if you started your loan after July 2010, you are most likely free of any worries about prepayment penalties. However, certain types of mortgages may still have them.
If you are worried that your mortgage might have one, a quick call to me is all it takes to find out. I am always here to help.