Prepayment Penalty

Key Takeaways
* A prepayment penalty is a fee a lender may charge if a borrower pays off or substantially reduces a loan balance early, typically within the first few years.
* Penalties protect lenders from lost interest income and are usually calculated as a percentage of the remaining balance or as several months’ interest.
* Lenders must disclose any prepayment penalty; borrowers should review the loan terms and consider alternatives without penalties.

What is a prepayment penalty?
A prepayment penalty is a contractual fee assessed when a borrower repays part or all of a loan earlier than agreed. It most commonly appears in mortgage contracts and is intended to compensate the lender for interest income lost when a loan is paid down, refinanced, or the property is sold soon after closing.

How prepayment penalties work
* When they apply: Penalties most often apply during an initial period (commonly the first two to three years) after loan origination, though some loans may have longer windows.
* How they’re calculated: Fees may be a fixed dollar amount, a percentage of the remaining balance (e.g., 4% of the balance), or an amount equal to several months’ interest. Some lenders use a sliding scale that decreases over time.
* What triggers them: Paying off the entire loan, making a large principal payment, refinancing, or selling the home can all trigger a penalty depending on the contract. Small, occasional extra principal payments usually do not, but borrowers should confirm this with the lender.

Types of prepayment penalties
* Hard prepayment penalty: Applies when the loan is paid off for any reason—sale or refinance.
* Soft prepayment penalty: Applies only if the borrower refinances; selling the property does not trigger the fee.

Legal limits and common exceptions
* Federal rules (post-2010 regulatory changes) restrict prepayment penalties on many mortgages. For loans originated after January 10, 2014, lenders generally may only impose prepayment penalties under certain conditions, limited to the first few years and capped in size. Lenders must also offer a comparable loan option without a penalty.
* Prohibited or restricted loans: Single-family FHA loans, VA loans, and most student loans do not allow prepayment penalties.

Practical considerations for borrowers
* Ask early and read disclosures: Confirm whether a prepayment penalty exists and how it’s calculated before closing.
* Compare loan offers: Look for loans that do not include penalties, especially if you expect to refinance or sell within a few years.
* Run the numbers: When considering refinancing, compare the penalty cost against potential interest savings to determine if refinancing still makes sense.
* Negotiate: Some lenders will offer similar rates without a penalty or will reduce the penalty period if asked.

Example
If a homeowner refinances a two-year-old mortgage with a remaining balance of $250,000 and the loan includes a 4% prepayment penalty, the fee would be $10,000 (0.04 × $250,000). That cost can substantially reduce or eliminate the benefit of refinancing.

Bottom line
Prepayment penalties are designed to protect lenders but can significantly affect the cost and timing of refinancing or selling. Always confirm whether a loan includes a prepayment penalty, understand the trigger conditions and calculation method, and compare penalty and no-penalty loan options before committing.