Mortgage Prepayment Penalty: What It Is and How to Avoid It

While many people dream of paying for a home in cash, this goal can be very challenging. Housing prices are surging all over the country, and some markets are so pricey it could take decades to save up enough the money you need for even a basic starter home. Plus, who wants to rent their whole life while they save up to buy a home?

couple signing mortgage papers

Fortunately, you don’t have to take out a traditional thirty-year loan and make only the minimum monthly payments. Instead, you could take out a mortgage of any length and pay more than the minimum to pay off your mortgage early. This strategy gives you the best of both worlds — a home to live in and the ability to get out of debt faster, provided you can afford to pay extra toward your mortgage each month.

Before you decide to pursue the strategy of paying off your mortgage early, however, it’s essential to make sure your mortgage doesn’t charge a prepayment penalty. While it may sound preposterous, some lenders charge prepayment penalties if you pay off too much of your outstanding loan balance in any given year — even if you’re selling your home so you can move.

What is a mortgage prepayment penalty?

A mortgage prepayment penalty is a fee that some lenders charge when a borrower pays some or all of a mortgage loan principal off early. The fee encourages borrowers to pay back their principal over the full term, allowing mortgage lenders to collect interest.

The fee doesn’t usually take effect if you make a few extra payments to pay off your principal balance sooner. Most lenders that charge the fee allow borrowers to pay off up to 20% of the remaining loan balance each year.

Soft Prepayment Penalties vs. Hard Prepayment Penalties

Before you borrow money to purchase a home, it’s crucial to understand if your mortgage has any prepayment penalties, and if so, which type. There are two types of prepayment penalties you should be aware of — hard and soft.

With a hard prepayment penalty, you will have to pay a penalty fee if you sell your home or refinance your mortgage within the first few years of the loan. While prepayment penalties vary among lenders, it could be up to 80% of six months of interest on your home loan.

On the other hand, with a soft prepayment penalty, you only have to pay the penalty if you refinance. However, you do not have to pay a prepayment penalty if you sell your home for any reason.

While paying 80% of six months of interest may not sound like a lot, this fee could add up quickly. Imagine you have a mortgage with a loan amount of $400,000 at a 6% APR, for example.

At that rate, you would pay approximately $2,000 per month in interest for six months — or around $12,000. A penalty fee equal to 80% of that amount would be about $9,600. That is a high price to pay for wanting to move or refinance to get a better deal.

However, it’s important to note that most prepayment penalties only apply to the first three to five years you have a mortgage. After that, you can sell or refinance without paying for the privilege.

The Problem with Prepayment Penalties

While getting a mortgage with a prepayment penalty may not be the end of the world, you may face notable disadvantages if your housing situation or your finances change. With a hard prepayment penalty, in particular, you would actually be penalized if you refinanced your home into a mortgage with a lower interest rate and better terms.

And, what if you need to relocate for a job or find yourself needing additional room for your growing family? A prepayment penalty would ding you then as well.

A soft prepayment penalty only applies if you refinance (and not if you sell), but it’s still not much better. You’ll still be stuck paying a significant prepayment penalty fee if you need to change your mortgage terms, and this fee could come at the worst possible time if you’re refinancing as a result of financial distress.

How can I avoid a prepayment penalty on my mortgage?

As you shop around for a mortgage for your new home, it’s crucial to read the terms thoroughly and understand any fees that may be charged, including prepayment penalties. The law requires mortgage lenders to disclose prepayment penalties along with other fees and loan details.

Ask your mortgage lender if they charge a prepayment penalty. While enduring a prepayment penalty clause may help you secure a lower interest rate, there are times when it just won’t be worth it.

Ideally, you should probably strive to avoid mortgage prepayment penalties if possible. While you may believe you won’t need to refinance or sell, you never know what life will throw your way.

It’s possible you could need to relocate for your job or need to upsize or downsize your home. If mortgage rates go down considerably, you could be in a position where you need to refinance to get a better deal.

It’s also possible your financial situation could change in such a way that refinancing could be the only way you could afford to stay in your home. For example, if you face a loss in pay, you could need to refinance into a new loan with a longer repayment timeline to get a lower monthly payment.

Shopping for a Mortgage

With all this in mind, here are some steps to consider as you shop for a new mortgage:

  • Check your credit score and take steps to improve it. Remember that the best mortgage rates go to those with good or great credit. If your credit score is on the lower side, it may be worth taking some time to improve your credit before applying for a mortgage. If your credit isn’t that great, you can also consider a government-sponsored home loan program like an FHA loan or USDA loan. Both home loans come free of prepayment penalties and they may be easier to qualify for with poor credit.
  • Shop around and compare home loans in terms of their interest rates and fees. Since mortgage lending is competitive and companies must compete for your business, it’s common for some lenders to offer better mortgage rates and terms.
  • Read the fine print. Before you make the final decision on your new mortgage, the Consumer Financial Protection Bureau (CFPB) advises reading through the details of your loan documents. If your mortgage has a prepayment penalty, make sure you understand how much it will cost and how long it lasts.

Bottom Line

Before you take out a mortgage, make sure you’re not setting yourself up for an unpleasant surprise. You should know how much your mortgage payment will be each month and exactly when your loan will be paid off, for example. On top of that, you should also be aware of any prepayment penalties or fees you’ll be charged if you need to refinance or move for any reason.

Generally speaking, it’s wise to avoid mortgages that charge a prepayment penalty. You may think you’ll remain in your home forever, but you never know how life could change in the next five years. By choosing a mortgage without a prepayment penalty, you’re keeping your options open and protecting yourself from expensive prepayment fees.

At the end of the day, you should try to find an affordable mortgage free of “gotchas” that can cost you big time when you least expect it. If you fail to read the loan agreement and wind up facing a big mortgage prepayment penalty, you could live to regret it.

Holly Johnson
Meet the author

Holly Johnson is a credit card expert, award-winning writer, and mother of two who is obsessed with frugality, budgeting, and travel.