Loans that have prepayment penalties are not as common as they used to be, but they still exist. Prepayment penalties are fees a borrower agrees to pay if they choose to pay off a mortgage early. The prepayment penalty period is often five years, though some loans have shorter or longer penalty periods depending on the original loan term.
There are two common types of prepayment penalties. The first type is circumstantial: the fee may be waived if the borrower sells the home during the penalty period or under other permitted circumstances. The second type is absolute: it cannot be waived for any reason.
Most people decide to pay off their mortgages early because they find a better deal or receive a large sum of money. A common situation is refinancing with a new loan to pay off the original mortgage. Many borrowers, however, do not take the prepayment penalty into account. In some cases paying the penalty and completing a refinance still saves money, but that usually applies only when the original loan has an extremely high interest rate.
Lenders don't assign prepayment penalties to be mean. From the lender's perspective, they must make money on their loans and rely on the interest calculated over the original loan term. If a loan is paid off early, the lender loses some of the interest income they expected, so a prepayment penalty offsets that loss. For information about services related to mortgage operations and property preservation, see Mortgage Field Services Insurance for Property Preservation & Inspection Companies.
Mortgage interest rates fluctuate. When average interest rates drop, many borrowers try to refinance to save money, and lenders cannot assume rates will remain stable. Prepayment penalties have appeared on both prime and sub-prime loans; historically they were sometimes added to sub-prime loans in combination with higher interest rates to offer borrowers an option. The prepayment penalty can also allow a borrower with a prime loan to obtain a lower interest rate on the original loan. For related mortgage field service needs and protections, see Mortgage Field Services Insurance for Property Preservation & Inspection Companies.
The best way to know whether a mortgage has a prepayment penalty is to look at the original loan contract. If the information is difficult to locate or you want help interpreting the terms, talk to an agent who can review the contract with you.
Frequently Asked Questions
What is a prepayment penalty?
A prepayment penalty is a fee charged when a borrower pays off a mortgage before an agreed period ends.
How long do prepayment penalties typically last?
Penalty periods commonly last around five years, but the exact length depends on the loan’s original term and the lender’s policy.
Can a prepayment penalty be waived if I sell my home?
Sometimes—circumstantial penalties may be waived for a sale or other permitted events, but absolute penalties cannot be waived.
Will refinancing always save me money even with a prepayment penalty?
Not always; paying the penalty plus refinancing costs may only save money when the original interest rate is very high or the new loan offers substantially better terms.