Four Things to Understand About Prepayment Penalties

Four Things to Understand About Prepayment Penalties
by: John Steely



If you have a mortgage, of any type, many people will give you the advice
to make extra payments on the mortgage in order to pay off the mortgage
that much sooner. Indeed, depending on the interest rate of the mortgage,
making extra payments has a return in line with the best money market
accounts. And you get debt free that much sooner. Whether or not you
should pay extra on your mortgage depends on many factors, and there are
many articles written about doing that; one of the factors involved is
whether there are prepayment penalties in your mortgage or not.

So, if you are going to make an informed decision about paying off your
mortgage early, whether through extra payments or through refinancing
your mortgage (which mortgage companies would love for you to do), you
need to understand what prepayment penalties are, how they work, and why
do they exist.

Types of Prepayment Penalties

If your mortgage has prepayment penalties, they are in place for a period
of time at the beginning of the mortgage. That period of time is anywhere
from two to five years; after that period is done, the penalty no longer
applies. The reason the prepayment penalty only exists for the first few
years of the mortgage is because the mortgage company has incurred
certain expenses in making the mortgage, above and beyond what you are
charged when the mortgage is closed. One example of such expenses is the
commissions paid to the people involved in originating the mortgage. The
mortgage company wants to make sure they get enough interest to cover
such expenses, so if you pay off the mortgage too early, they will put a
prepayment penalty to collect enough money to cover such expenses.

There are two types of prepayment penalties. The hard prepayment penalty
is one that is charged regardless of how the loan is paid off. No matter
what the circumstances, a hard prepayment penalty will be charged in
addition to the monies needed to pay off the principal. The soft
prepayment will not be charged under certain conditions; the two most
common ways to avoid a soft prepayment penalty are either to sell the
house or to refinance the mortgage through the original lender. If you
simply put enough extra money into the mortgage or if you refinance
through another company, the soft prepayment penalty will be charged.

How is the Penalty Calculated

Prepayment penalties will be triggered when one of two conditions is met;
the mortgage must specify which conditions apply. The first type of
penalty will is called a first dollar penalty, and it will be triggered
whenever any extra money is applied to the principal. The usual
calculation with this type of penalty is 80% of the interest owed on the
extra money. Let us say you have a loan at 7% and you put an extra $100
on the principal one month. This type of penalty will charge you 80% of
the 7% interest due on the extra $100, or $5.60. The exact details are in
your mortgage. This penalty will be due every time you make extra
payments on the principal.

The second type of penalty is called the 20% penalty. In this case, the
penalty is triggered when you have paid an extra 20% of the principal.
Again, let us say you have a mortgage of $150,000 at 7% interest. With
this penalty, nothing will be charged until you have made extra payments
totaling $30,000. When this amount is reached, you will be charged 6
months interest on 80% of the remaining principal. For example, let say
in the above mortgage you made regular payments and reduced the principal
down to $140,000, and then you came into an inheritance and put $30,000
on the loan, thus reducing the principal down to $110,000. Your penalty
will be 6 months interest of 7% on $88,000, or $3,080. This penalty will
be due the first time the trigger event occurs, but only the first time.

Many states put a cap on the size of the prepayment penalty. For example,
my state, Virginia, has a cap of 2% of the owing principal as a penalty.

Why should I accept a Prepayment Penalty

Many people will tell you to never accept a mortgage with a prepayment
penalty of any type; they will tell you it limits your options. However,
the mortgage company will compensate you for a prepayment penalty in one
of two ways; they will either reduce the interest rate of the mortgage
by, say, half a percentage point, which could save you several thousand
dollars over the life time of the mortgage, or they will reduce the loan
points at the time of closing by one or two points, which again can save
you a couple of thousand dollars.

The issue is where you see yourself heading. If you are planning on
moving in the period covered by the prepayment penalty, then it may be
worth your while to accept the higher rate or points so that you will not
incur the penalty. If you are comfortable with the idea of not moving
during the prepayment penalty period of two to five years, take the
penalty and the lower rate and/or points.

Explicit Penalties Only

In either case, whether you have a mortgage now or not, the prepayment
penalties must be spelled out in detail in the mortgage contract. If you
are unsure, have a financial professional look at the mortgage; such a
professional is trained at understanding this type of clause.

If someone comes to you with a deal, particularly a refinancing deal,
make sure you know what you would have to pay before you accept the
promised loan. You may be surprised to find all your supposed savings
eaten up by these kinds of penalties and fees. A lower rate does not
always make the best deal.

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About The Author
John Steely has been a teacher for over 25 years, in such areas as
mathematics, finance, and leadership. For the last 5 years, he has been
providing services as a financial planner.


Visit the author's web site at: http://www.learningmoneybasics.com