Prepayment Penalties

So what is the big deal with prepayment penalties? Are they a rip-off? Should I take a loan with one? These are very common questions. The following is a very quick summary of the pros and cons of a prepayment penalty.

What is a prepayment penalty? A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Penalties are usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest.
Usually, prepayment penalties decline or disappear with the passage of time. Seldom do they apply after the fifth year. Partial prepayments of up to 20% of the balance usually are allowed in any one year without a penalty. A penalty that applies to a home sale as well as a refinancing, is a "hard" penalty; if it applies only to a refinancing, it is a "soft" penalty.

First, you as a borrower are classified as a prime or sub-prime borrower. If you are prime, you have good credit and qualify for a conforming loan. If this is the case, a prepayment penalty is something that you should avoid. The only scenario that is different is if a penalty works in your favor for your unique situation. For example, You just moved to Columbia and know you will be working at the University of MO for 4-5 years and then you will move on to another University. When you purchased your home you took a loan that offered a lower interest rate if you elected to have a 2 or 3 year prepayment penalty. As you can see in this situation, you can get the lower rate and payment and the penalty will not affect you. The only drawback is if some emergency situation came up and your plans changed. This is doubtful, but possible. Assuming no emergency comes up, you can sell and move on and you enjoyed the savings of the lower rate!
As a Prime borrower, keep in mind you also have more bargaining power when discussing prepayment penalties. With certain lenders you have options like its duration and a penalty only for refinancing, not selling. Just ask what is available.

If you are a sub-prime borrower, your options change! You do not have many options and the lenders offering these loans don't give you much choice. They simply don't make enough money on sub-prime loans without prepays and wont offer them. Now as I say your options are limited, always ask what is available. You may be able to negotiate between a couple options. If you are able to choose a loan without a pre-pay, the rate will be higher. Since sub-prime loans already have higher rates, this is not a very appealing option!

Now that you know the difference in pre-pay options for prime and sub-prime loans, lets look at a couple other points.

Before you raise a big stink about a pre-pay and pass on a refinance that will greatly help your current situation, consider the worst case scenario penalty. If your mortgage is small and your penalty is 2% of the unpaid balance, the amount may not be that large. Say you own a home worth $150,000 and you owe $80,000. You need to refinance to payoff some credit cards that are hounding you. If your penalty is 2%, your penalty would be $1,600. This may be worth it since you have the equity and the new loan will make your life much easier!
Now if you owe $400,000 and your penalty is $8,000, things may change a bit.

Occasionally, you may receive a letter in the mail from your lender asking you to add a prepayment penalty. Some people can be duped into this. There is absolutely not reason to agree to this. Unless they offer you a lower rate in return, just decline this attempt. The reason they want this is because your loan is worth more if sold on the market with the prepayment penalty.

In summary try to avoid a prepayment penalty if possible. However, just stay calm and analyze the entire situation if your loan officer is telling you that it is not an option unless you want to pay a higher rate . Some situations may make it impossible for you to accept a penalty and others will allow for it. Remember, the loan officer doesn't enjoy offering these penalties. They are doing so because they have no choice or are trying to give you options that will offer a lower interest rate.

Questions and Comments are welcomed?

Professional Mortgage Group, Inc.
Columbia, MO