Understanding a Mortgage Prepayment Penalty

This confusing term sounds like a bad thing, but it's often a good one.

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Although not as common as they were just a few years ago, there are still various loan programs that give people an option to have a prepayment penalty.

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Should you get a mortgage that has a prepayment penalty, it means that you are agreeing in writing that if you "prepay" the mortgage before a specified period of time—usually less than 5 years—then you agree to pay a specified "penalty" to the lender.

Some prepayment penalties require you to agree to the penalty only under certain circumstances, for example, you may not have to pay if you sell your house, while others require you to pay the penalty regardless.

When a lender gives you a loan, they have calculated their expected return on the mortgage and built it into their models, even calculating the amount of time they expect you to have the mortgage before it "prepays."

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A lucky few win the lottery but the most common reason that someone prepays a loan off before the maturity is because they were able to find a loan offered by another lender with a lower interest rate and refinanced out of their current mortgage and into a new mortgage. When mortgage interest rates drop, many people refinance and prepay numbers go up dramatically.

How to Tell If You Have a Prepayment Penalty

The easiest way to find out if you currently have a prepayment penalty is to dig out the paperwork you have from when you signed your final paperwork and look for your mortgage note. There usually will be wording in your note that outlines the prepayment penalty terms. Sometimes there will also be something called a "Prepayment Penalty Rider," but it will vary depending on when you closed your loan and your lender.

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Are Prepayment Penalties "Bad"?

A few loans like a FHA loan, VA loan or USDA loan never allow a prepayment penalty. Does this mean that prepayment penalties are bad? Prepayment penalties aren't bad—in fact, I tend to view them as a potentially good thing. For example, let's say that in exchange for agreeing to a prepayment penalty a homeowner:

  • Is aware of the prepayment penalty, what it means and what the terms of the prepayment penalty are and
  • Received a lower interest rate and/or lower closing costs and
  • Is given the choice of having the prepayment penalty
  • Then, a prepayment agreement can be a good thing for both homeowner and lender. The simple reason many people think that prepayment penalties are "bad"? In the past people haven't been made aware of these three things.

    Justin McHood is a guest contributor to the Zillow Blog, a resource for real estate and mortgage news. Twitter: @zillow.