Understanding Mortgage Prepayment Penalties

A mortgage prepayment penalty allows the lender to charge a borrower additional interest if the mortgage is repaid during a specific period of time. If a mortgage loan does include a prepay penalty, it should be clearly stated within the mortgage disclosures, mortgage note or prepayment penalty rider to the note. Conforming, low interest rate loans do not have mandatory prepayment penalties. More creative, non-conforming mortgages will usually require the borrower to agree to a prepay penalty clause.

How Prepay Penalties Work

Prepay penalties usually kick-in if the loan is paid off within the first 3 to 5 year period. Some lenders collect a flat 2% of the outstanding loan balance as a penalty. In other cases, the penalty starts at 3% of the balance, then declines by one percentage point a year. A common penalty practice used by many sub-prime lenders is 6 months of interest on 80% of the loan balance. For example, on a loan balance of $200,00 with 7% interest, the penalty would be $5,600. You can get a rough estimate of the penalty by multiplying the monthly mortgage payment by 5.

Two Types of Prepays

There are two types of prepay penalties. There are soft prepayment penalties and hard prepayment penalties

1. A soft prepay penalty will allow the borrower to sell their home at anytime without penalty. If the borrower chooses to refinance the mortgage, they will pay the prepay penalty.
2. A hard prepay penalty does not allow the borrower to sell their home or refinance their mortgage without a penalty. This type of prepay penalty gives the borrower much less room if they need to sell their home quickly.

Prepay Penalties For Sub-Prime Loans

Including prepayment penalties on sub-prime mortgages is common practice, which are given to borrowers with tarnished credit, a sketchy employment record or a heavy debt burden. But in recent years, prepay penalties have been showing up more on mortgages made to borrowers with good credit history, in order to get a lower interest rate.

Prepay Penalty Option For Better Terms

Many lenders say that a prepay penalty is an “option” they offer to borrowers seeking better terms. In return for opting for the penalty, borrowers will generally get a rate about one eighth to three eighths of one point below the market rate. Buyers tend to choose the penalty option when rates are rising. Whether a prepay penalty is a wise decision really depends on what happens to interest rates once the loan is locked in. Obviously, if rates go up, the borrower is looking good, but if rates go down significantly, the borrower isn’t in such a great position.

Pros And Cons

To better understand the pros and cons of prepay penalties, take a look at two possible scenarios: 

• With a mortgage of $200,000 at a 7% rate, if the borrower can reduce the rate to 6.75% by agreeing on a penalty of 2%, the borrower saves $1,507 in interest during the 3 years when the penalty is in effect. If the loan remains for the full 30 years, it would be a savings of $12,000.
• If interest rates fall and the borrower wants to refinance in 24 months, he/she would wind up with a $3,912 penalty. The cost is only minimally offset by the interest saved in obtaining the lowered interest.

Many lenders believe that the benefits don’t out-way the risks involved with prepay penalties. According to Thomas Garvey, an executive vice president with J.P. Morgan Chase, “The price point isn’t that much better for a loan without a prepayment penalty.” Garvey states that Chase uses prepayment penalties only on loans in their sub-prime division.

Whether you choose the prepay penalty option for a better interest rate or obtain a non-prime loan with a mandatory penalty clause, make sure you “fully understand” the terms of the penalty. 

For more information on mortgages, visit the experts at New Homes Central Lending. 

[tag]Mortgage Prepay Penalties, Mortgages, Home Loans, Buying New Home, New Home Purchase[/tag]

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