PREPAYMENT PENALTIES
When you are considering taking out a home loan, whether for a purchase or refinance, you should ask your lender whether the product they are offering contains a prepayment penalty clause. It may be that a prepayment penalty makes sense, or not, but it is important that you understand how it works before you sign on the dotted line.
First, exactly what is a prepayment penalty? It's just interest paid to the lender if the mortgage is paid off before the agreed upon term. There is a financial cost to the lender if you pay off the loan before it's full term. Prepayment penalties vary, but a typical penalty is six months worth of mortgage interest. Most loans with prepayment penalty clauses typically apply during the first two to five years only, with no penalty thereafter. And some states outlaw them completely or place restrictions on them.
There are usually two types of prepayment penalties, sometimes called "hard" and "soft."
A hard penalty is one that applies throughout the term of the loan, regardless of how the mortgage was paid off. Penalties for refinancing, selling or even making additional principal payments usually define a hard prepayment loan. Hard prepayments are mostly applied to offset borrower risk factors like damaged credit or hard to prove income - and to assure that the lender gets as much interest as possible from the loan.
Less costly, is the soft prepayment. Soft prepayment clauses usually last only 2 to 5 years and do not apply if the house is sold, only if refinanced. Further, most soft prepayment loans allow for extra payments to principal so long as the extra payments do not exceed 20 percent of the principal balance during any 12-month period. On a $100,000 mortgage, you can usually pay off $20,000 extra per year without penalty. Soft prepayments usually are designed to offset a lower initial rate - in effect, they give the lender some time to recoup for that low up-front rate. So why do borrowers accept such loans?
A hard prepayment penalty may apply with a loan issued to someone whose credit is under repair and represents a higher risk of default. In exchange for making a loan under these circumstances, a lender wants to assure a certain return on their investment. Consumers are less likely to pay off a prepayment penalty loan if they have to come up with 6 months interest at closing.
Soft prepayments are sometimes offered for the same reason, to insure a specified return on a mortgage loan, but why would someone with perfectly good credit accept such a loan?
To get a lower interest rate!
A typical 30-year fixed mortgage rate might be reduced by .25% if the borrower accepts a prepayment clause. Usually borrowers who negotiate a lower rate with a prepayment penalty are planning to stay in the home for an extended period, don't see a need to refinance in the near future, and realize that if rates go marginally lower it may not pay to refinance. This strategy can be useful when rates are low & chances of them going much lower are minimal.
Most lenders offer loans with soft prepayment penalties, but rarely advertise them due to the scary terminology used...the word "penalty." But if you can save on your mortgage interest every month and can live with soft prepayment terms, why not ask what's available? In all cases, of course, you want to check the numbers and be sure you fully understand what you are signing up for.
