Understanding Prepayment Penalties on Home Loans

Posted by Nick Niesen on October 29th, 2010

Mortgage lenders prefer certainty to chaos. Some lenders take this concept to its logical conclusion in mortgages by inserting prepayment penalty clauses.

Understanding Prepayment Penalties on Home Loans

When a mortgage lender evaluates a loan application, it performs a number of analyses to determine risk and profit scenarios. For many lenders, the analysis is based upon a certain period where they are absolutely sure you will be paying back the loan. To make sure this happens, they put prepayment penalties into the loan documents. While you can still refinance, the penalties usually make it a dubious financial decision.

Prepayment penalties are simply arbitrary provisions that require you to pay a fee if you pay off a home loan before a certain point in time. The penalties can be the equivalent of points, a number of payments or a set fee. There are a wide variety of penalties because the law governing them is set by the states, not the federal government. Since states rarely pass the same law, each has its own set of rules on what lenders can and cannot due. You will need to check the laws of your state or speak with a mortgage broker to figure out where you stand.

Prepayment penalties can be staggering. Regardless of the formula used to determine them, you can expect a penalty equivalent to the maximum allowed under the laws of your state. The lender wants you to continue to meet the obligations of the original loan. If you try to refinance, they will want their piece of flesh. This is true even if you must sell the property because of an emergency, divorce, lost job or other unfortunate things that can occur in life.

Whenever possible, you should avoid mortgages that have prepayment penalty clauses included in them. They simply are not worth the aggravation. If you must accept penalty clauses, try to shop for a loan that has the shortest penalty duration. Some lenders will want the prepayment penalty to apply for the full length of the loan while others may require only a year or two. It is strongly advised that you avoid any loan that contains a prepayment penalty for the life of the loan. You will regret agreeing to such a loan in the long term.

Fortunately, the home loan industry is a competitive one. To compete for your business, most mortgage lenders have moved away from prepayment penalty clauses or at least limited their bite. Still, make absolutely sure you avoid these brutes if at all possible.