What is a Prepayment Penalty?

Mortgage Pre-Payments can be expensive! This handy video shows you the two most common ways lenders calculate penalties.

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Prepayment Penalty Definition

A prepayment penalty is a sum of money paid to the mortgage holder if the mortgagor decides to pay off the mortgage before the end of its term.

A prepayment penalty may also apply if you pay down the mortgage more than is allowed by the mortgage contract.

Because a mortgage lender earns income through the interest you pay, they lose income if you pay off the mortgage prior to its maturity date. Thus, a prepayment penalty has become a common provision in many mortgages however, not all mortgage loans contain prepayment penalties. Normally, a prepayment penalty is calculated in two ways. The penalty is usually the greater of:

  • Three months interest, based upon the current mortgage loan balance; or
  • The interest rate differential, (IRD) which is the difference between how much you would pay with your original mortgage interest rate and how much you would pay based on the interest rate that the lender can charge today. Banks will normally post their current lending rates, so the prepayment penalty based in IRD can be easily calculated.

Example 1

Three months interest pre-payment penalty

You have a $200,000 mortgage balance at 5% interest with 20 months remaining on the mortgage term. The approximate monthly interest is $833.33. If you pay off your mortgage loan early, and the mortgage holder charges a prepayment penalty based on three months interest, your prepayment penalty will be $2,500.00, or $833.33 times three.

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Example 2

IRD based prepayment penalty

With the same mortgage as in example 1, the current mortgage rate charged by your mortgage lender is 4%. The formula is more complex than in example 1.

The IRD is 1%. This is calculated by subtracting 4% (the prevailing interest rate at the time of the prepayment), from 5% (the original mortgage rate). Since the mortgage balance is $200,000, the monthly interest IRD is $166.66. When you multiply this by the remaining mortgage term of 20 months, the prepayment penalty will be $3,333.33.

Avoiding or Lessening Prepayment Penalties

First and foremost you may choose to seek out a mortgage lender who does not charge prepayment penalties, also referred to as an open mortgage. It can be a difficult task and will often be a little higher in order to compensate for the loss of interest by the lender.

Prepayment penalties are found most commonly on fixed rate mortgages with a closed term while variable rate mortgages, if there is a prepayment penalty, will only charge the three months interest. Home equity lines of credit do not charge prepayment penalties. By law, if the mortgage term is more than five years and more than 5 years has been paid, the mortgage holder is required calculate the penalty using the three month interest method.

Often, when refinancing, the prepayment penalty from the former lender may be financed with the new lender, and can be added to the principal of your mortgage. Even with a prepayment penalty added to your principal you can still come out ahead, especially if you are near the end of your mortgage term.

At First Foundation, we can determine what your prepayment penalty would be if you choose to refinance, based upon current market mortgage rates. We can help you find ways to lessen a prepayment penalty, and determine whether it would be beneficial to you to refinance with a prepayment penalty.

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If you are interested in learning more about prepayment penalties, please feel free to contact us today!

Last updated Mar 15, 2019