What Is a Prepayment Penalty on a Mortgage and Why Does It Matter?

What Is It?

Lenders charge a prepayment penalty when a person pays their mortgage off early. They use the fee as an incentive to keep those who borrowed paying their principal over time. This is because lenders make their money off on interest, and when there is an early payment of a loan, it affects the interest income. Prepayment penalties typically do not happen when an extra payment or larger payments happen. They tend to kick in when selling, refinancing or paying off more than 20% of the balance in a year.

What Is a Prepayment Penalty on a Mortgage and Why Does It Matter?
Understanding Prepayment Penalty on Your Mortgage

How Much Does It Cost?

Prepayment penalty rates vary from loan to loan. Some terms will help you understand how a lender sets the charges for you. With a fee based on the percentage of the remaining loan balance, there is a payment of a small amount, such as 2%, if a borrower pays off the loan entirely in a few years.

A certain number of months in interest is the given interest over a set period that a borrower pays. A fixed amount means a fixed number outlined in the loan agreement. A sliding scale means the rate is based on how quickly a borrower pays off the loan. For instance, 2/1 would mean you pay 2% if the loan is paid off in the first year, the penalty is 2%, and if paid in the second year, it is 1%.

Why Is It Charged?

When you borrow money from an individual you know personally, they want it returned ASAP. This is not the case with professional lenders. The initial years of a loan carry more risk, especially if the borrower has a small amount invested. This is why lenders charge interest. They can offer lower interest rates because they know they will make money over the life of the loan. The prepayment penalty exists to help balance it when the loan doesn’t take as long to pay.

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