Prepayment penalties are imposed by some lenders on borrowers who either pay off, or pay down, their mortgage loan ahead of schedule. But take note, some states don’t allow these prepayment agreements and others have restrictions on them. Check your state regulations before you start your home search.
Prepayment penalty agreements usually last for three years. But even during these three years, borrowers will be able to pay off up to 20% of the principal per year without incurring the penalty. After that period, penalties won’t apply, even if you totally pay off your mortgage.
Penalties can be substantial
Penalties vary by lender, and can amount to the better part of six-month’s interest. For example, on a 30-year, $150,000 mortgage at 4%, six months of interest totals $2,989.15 – not a negligible amount.
To compensate for offering a lower interest rate, some lenders will include a prepayment agreement on a mortgage. This means the lender, and the investors who purchase their loans, will make something on the loan if you refinance, want to take advantage of lower interest rates or sell earlier than you anticipated.
If you are considering a loan that has a prepayment penalty, ensure you fully understand the terms. And know your options: If, for example, you expect to relocate during the penalty period, you may want to look for loans without prepayment penalties. If you plan to stay in your home, but would like the choice to refinance during the penalty period if interest rates decline, you’ll also want to consider your options.