Prepayment Penalties

When you get a mortgage, sometimes the lender will want to impose a prepayment penalty. A prepayment penalty is a provision stating that if you pay off the loan entirely, you will be subject to a penalty, usually expressed as a percentage of the outstanding balance at the time of payment, or a specified number of months’ worth of interest. These penalties usually disappear or decline with time, and are rare after five years. Hard penalties apply both to a sale of your home and refinancing, soft penalties apply only to refinancing.

Depending on what type of borrower you are, prepayment penalties serve different purposes. If you are a prime borrower, meaning you have good credit and are making a large down payment, a penalty will not generally be required. However, you can often choose to take a prepayment penalty in exchange for a lower rate. Many prime borrowers don’t think the small interest, and therefore payment, reduction is worth the penalty, but the option is there for those who choose to take it.

If you are a sub-prime borrower, meaning you have bad credit or cannot afford much of a down payment, you may be required to take a pre-payment penalty in order to be approved for a loan. This is because the lenders risk of refinancing is much higher on these loans than on prime loans. Sub-prime loans carry a higher interest rate than prime loans. If the borrower’s credit improves, he would be able to refinance after a couple of years to a much more advantageous interest rate, no matter how the market is doing. A prime borrower, on the other hand, will only be helped by refinancing if interest rates fall.

Lenders take a greater risk of default on sub-prime loans as well, which is the reason for the higher rates. If they allowed all the good loans to leave quickly through refinancing lenders are less likely to profit through making these types of loans. However, if you are a sub-prime borrower, you can still negotiate a more favorable penalty, even if you cannot avoid one altogether.