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 even for a 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 mortgage 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 imposed by some lenders when a borrower pays off their mortgage loan earlier than the agreed-upon schedule. This fee can be triggered by either paying a significant portion of the loan balance or refinancing the mortgage. The rationale behind this fee is to compensate the lender for the interest payments they will miss out on due to the early repayment.

Types of Mortgage Prepayment Penalties

There are mainly two types of mortgage prepayment penalties: soft and hard.

Soft Prepayment Penalties

This penalty is applied only when you refinance your mortgage, leading to an early payoff of the original loan. However, if you sell your home, you won’t be charged this penalty. Soft penalties are generally more borrower-friendly, offering some flexibility.

Hard Prepayment Penalties

These are more stringent. A hard prepayment penalty is charged not only when you refinance, but also if you sell your home. This means that any action leading to the early payoff of the mortgage, whether it’s selling your house or refinancing it, will incur a penalty. Hard penalties can be financially significant and are a crucial factor to consider when agreeing to a mortgage.

Why do mortgage lenders charge prepayment penalties?

Lenders charge prepayment penalties for a few reasons:

  1. Interest revenue: The most apparent reason is the loss of interest revenue. When a borrower pays off a loan early, the mortgage lender misses out on future interest payments they had counted on.
  2. Loan pricing strategy: Some mortgage lenders offer lower initial interest rates or more favorable terms on the assumption that they’ll earn interest over a longer period. Early repayment disrupts this strategy.
  3. Risk management: From a lender’s perspective, prepayment can introduce financial unpredictability. The penalty is a way to mitigate this risk.
  4. Secondary market influence: Loans are often sold on the secondary market. Investors in these loans expect a certain return, calculated based on the loan’s expected life. Prepayments can disrupt these expectations, and penalties help to balance the equation.

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 to Avoid Prepayment Penalties

One of the most critical steps in avoiding prepayment penalties is to thoroughly read and understand your mortgage terms. Often, the details regarding prepayment penalties are buried in the fine print of the mortgage agreement.

It’s essential to review these terms carefully before signing. Look for sections titled “Prepayment,” “Prepayment Penalty,” or similar headings. Understand the conditions that trigger the penalty, the calculation method, and the duration for which the penalty applies.

If the document is complex or uses technical jargon, consider consulting a real estate attorney or a financial advisor for clarification.

Questions to Ask Your Lender

When discussing mortgage options with your lender, it’s crucial to ask direct questions about prepayment penalties. Some questions to consider include:

  1. Does this mortgage have a prepayment penalty? – A straightforward question to start the conversation.
  2. What are the specific terms of the prepayment penalty? – Ask for details like the amount, duration, and conditions.
  3. Under what circumstances does the penalty apply? – Clarify if the penalty is triggered by refinancing, selling, or making large payments.
  4. Is the prepayment penalty clause negotiable? – Find out if there’s room for negotiation on this aspect.
  5. Can you provide a loan option without a prepayment penalty? – Express your interest in alternatives without such penalties.

Negotiating Mortgage Terms

Negotiation is a powerful tool in securing favorable mortgage terms. Here are some strategies to help negotiate out of a prepayment penalty:

  • Shop around: Before settling with one lender, shop around. Use offers from other lenders as leverage in your negotiations.
  • Highlight your creditworthiness: If you have a strong credit score and a stable financial history, use this as a bargaining chip. Lenders are more likely to offer favorable terms to low-risk borrowers.
  • Be upfront about your plans: If you intend to pay off your mortgage early or think you might refinance, let your lender know. This can open up discussions for more suitable mortgage products.
  • Ask for a trade-off: If the lender insists on a prepayment penalty, negotiate for a lower interest rate or other benefits to offset the potential penalty.
  • Seek professional advice: A mortgage broker or financial advisor can provide valuable insights and negotiation tactics specific to your situation.

Remember, knowledge and negotiation skills are key to avoiding prepayment penalties. By understanding your mortgage terms, asking the right questions, and effectively negotiating, you can secure a mortgage that aligns with your financial goals and offers the flexibility you need.

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

Your credit score plays a pivotal role in determining the terms of your mortgage, including interest rates and eligibility for certain loan types. Higher credit scores typically unlock lower interest rates and more favorable loan terms.

If your credit score is not in the ‘good’ or ‘excellent’ range, it’s advisable to take steps to improve it. This could include paying down debts, ensuring timely bill payments, and correcting any inaccuracies on your credit report. Even small improvements in your credit score can lead to significant savings over the life of a mortgage.

Comparing Mortgage Offers

When shopping for a mortgage, it’s essential to compare offers from multiple lenders. Look beyond just the interest rates; consider the overall loan terms, including fees, loan duration, and flexibility.

Use a mortgage calculator to understand the long-term implications of each offer, including the total interest you’ll pay over the life of the loan. It’s also crucial to compare prepayment penalties, as these can significantly impact your financial flexibility and cost you more if you decide to pay off your mortgage early or refinance.

Government-Sponsored Home Loan Programs

For those with less-than-ideal credit, or who are seeking more flexible qualification criteria, government-sponsored home loan programs like FHA (Federal Housing Administration) and USDA (United States Department of Agriculture) loans can be excellent alternatives.

These home loans often come without prepayment penalties and can be easier to qualify for compared to conventional loans. FHA loans are known for their lower down payment requirements and more lenient credit score criteria, making them suitable for first-time homebuyers.

USDA loans, targeted at rural and suburban homebuyers, offer benefits such as no down payment and competitive interest rates. However, they come with specific eligibility requirements related to the location of the property and the borrower’s income level.

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 contract 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. Moreover, 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.