Prepayment Penalty

What Is A Prepayment Penalty?

A prepayment penalty is a fee a mortgage lender charges when a borrower pays all the loans or a considerable part of them early.

Deeper Definition 

Often, when people get a loan, they can’t wait to pay it off and be debt-free. Although it is an excellent habit to form, a mortgage lender discourages it by charging a prepayment penalty to borrowers who repay a loan or a significant part of a loan too early.

A prepayment penalty is the fee mortgage lenders charge to dissuade borrowers from paying off their mortgage before its full term. When borrowers pay a loan off right away, mortgage lenders lose the interest they would gain if the loan were to run for years. Prepayment penalties serve as protection for lenders against losing interest.

Not all mortgage lenders impose the penalty and those who do usually include it in the mortgage contract clause. A mortgage lender must inform a borrower about this penalty before closing the deal so they know what they are getting. As with every contract, it is always good to read in between the lines carefully before signing the dotted lines.

The terms and conditions that make up a prepayment penalty vary from one member to another. However, in most cases, the penalty kicks in when a borrower pays off a loan within three to five years. Sometimes, the penalty may be enforced when a borrower pays off a significant portion of the loan at once.

There are various ways that a lender may use to determine the penalty cost. They may assign a small percentage, i.e., 2%, of the outstanding principal or ask the borrower to pay a total of a certain number of months interest, such as six months.

Prepayment Penalty Example

Mark obtained a loan from a mortgage lender for 25 years. Three years after getting the loan, Mark earned a considerable profit from an investment he made. Wanting to be debt-free, Mark decides to pay off the mortgage instead of running the 25 years term. However, the mortgage contract Mark signed stipulates that if he pays the loan off within the space of five years, he must pay 3% of the principal as a penalty. Since Mark does not want to pay the fee so he waits until the five-year period elapses.