What is a loan prepayment penalty? | Mortgages and advice | SehndeWeb

Paying off your loan early can save you hundreds or even thousands of dollars in interest, but if your loan has a prepayment penalty, you may end up with fees.

Thanks to federal legislation, prepayment penalties are less common than before. In fact, many mortgages don’t come with a prepayment penalty. But some loans, including some mortgages, may carry prepayment penalties. It is therefore important that you know if yours does and what to expect if it does.

What is a prepayment penalty?

Prepayment penalties are fees that some lenders may charge borrowers who repay part or all of their loan earlier than stipulated in the terms of the loan agreement.

“The sooner you pay off the loan, the less interest you’ll pay,” says Michael Sullivan, personal financial consultant at Take Charge America. “So the less the loan is going to cost you, the less the house is going to cost you.”

Prepayment penalties should never surprise the borrower. A lender cannot impose a prepayment penalty unless the penalty was included in the original terms of the loan. In other words, the borrower must agree to this stipulation when agreeing to the terms of the loan.

“Prepayment penalties are limited to specific types of loans. And even then, buyers should have a no-prepayment option. They’re never needed,” says Dan Green, CEO of Homebuyer.com, based in Austin, Texas.

Why do lenders charge prepayment penalties?

Although prepaying a loan is almost always a good thing for the borrower, it’s not so good for the lender. When a borrower prepays a loan, it deprives the lender of months or years of interest that the lender would otherwise collect on the loan.

“Remember, lenders make money by lending you money,” says Cynthia Meyer, certified fee-paying financial planner at Real Life Planning in Gladstone, New Jersey. “The interest you pay on your mortgage or loan is the lender’s income. The outstanding principal is an asset on the books of the lender. »

For this reason, some lenders use prepayment penalties to deter you from paying off your mortgage early. The longer it takes you to pay off your home loan, the more money the lender collects in interest.

“The lender charges a prepayment penalty to discourage prepayment of the full loan balance,” Meyer says. “For a mortgage lender, this discourages borrowers from refinancing a loan quickly in times of falling interest rates.”

Which loans have prepayment charges?

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act added new requirements for mortgagees and managers, including stricter guidelines regarding prepayment penalties.

After the law came into effect, the Consumer Financial Protection Bureau was tasked with implementing the new rules. Thus, since 2014, prepayment penalties are prohibited for certain types of mortgages.

According to the Federal Register, the provisions of the Dodd-Frank Act “generally prohibit prepayment penalties, except for certain qualified fixed-rate mortgages where the penalties satisfy certain restrictions and the creditor has offered the consumer an alternative loan without these penalties”.

FHA, VA, and USDA loans cannot have prepayment penalties.

For lenders who impose these penalties, prepayment penalties cannot be imposed after the first three years of the loan term.

Student loans do not have prepayment penalties, although some personal loans and business loans may, depending on the lender.

How much are prepayment penalties?

There are limits on how much your lender can charge you in prepayment penalties.

In the first two years of the loan, prepayment penalties cannot be greater than 2% of the outstanding loan balance or greater than 1% of the outstanding loan balance in the third year of the loan. Your lender determines how much you will pay in prepayment penalties. The exact amount may vary depending on the lender.

One of the most common methods of imposing a prepayment penalty is on a sliding scale, determined by the term of your mortgage. For example, if you pay off the mortgage in the first year of the loan, you may owe 2% of the principal balance remaining on the loan. Wait until the second year to repay the loan and you may owe a penalty equal to 1% of the mortgage balance.

Some lenders may simply choose a percentage of the overall loan balance and use that as a prepayment penalty in any case.

“Lenders can also charge a fixed penalty or a number of months of interest,” Meyer explains.

What are the benefits of prepaying a loan?

Paying off a loan early can save you hundreds or thousands of dollars in interest charges. And because you pay less interest, the loan will cost you less.

“So basically if you’re paying off a loan early, you’re saving money on the cost of the house,” Sullivan says.

Paying off your mortgage frees up money in your budget that would otherwise be used to make your monthly loan payment.

“When you have to pay for your child’s college education or need to save for retirement, you’ll have extra money because you’ve made those prepayments on the house,” Sullivan says.

Should you take out a loan with prepayment charges?

Sullivan says that for most people, it probably doesn’t make sense to take out a loan with a prepayment penalty.

“The benefits should be large enough to absorb the risk,” he says.

Even if you weigh the pros and cons carefully, the risk of incurring a prepayment penalty may still turn out to be greater than it first appears. For example, you can plan to stay in your home for three or more years after buying it, avoiding any possibility of being hit with a prepayment penalty. But things can change.

“No one knows for sure how their health is going to be, or the health of family members, or work situations or major disasters,” Sullivan says.

These risks underscore the potential downside of taking out a prepayment loan.

Meyer says there may be situations where accepting a prepayment penalty might make sense, especially if “you’re willing to accept the risk of a prepayment penalty in exchange for a lower interest rate.”

However, you may find that weighing the pros and cons of the lower rate against the prepayment penalty makes such a loan less attractive than it first appears. “It doesn’t make sense to everyone,” Meyer says.

Green says loans with prepayment penalties are not a good deal for consumers and adds that he thinks it never makes sense to take out a loan with a prepayment penalty.

“Prepayment penalties are not consumer-friendly,” he says. “Find a better option.”

How to avoid loan prepayment penalties?

It is essential that you understand the terms of your loan and know if prepayment penalties may apply. Knowing what’s in your contract — and what actions can result in a prepayment penalty — is crucial to avoiding triggering one of these charges.

“Where a prepayment penalty exists, it kicks in when the loan is paid off in full through a sale or refinance of the home,” Green says. “Some loans with prepayment penalties also trigger when the homeowner pays off their balance by 20% or more.”

By law, lenders must disclose whether and how they charge prepayment penalties.

“You have to accept a prepayment penalty when you buy the home or the investment property,” Meyer says. “He doesn’t magically appear after the loan is closed.”

Read the loan estimate and other documents carefully and make sure you understand what you’re getting into before signing any documents, as terms may vary from lender to lender. Also note if there are special situations where prepayment penalties may be waived.

“It’s common for prepayment clauses to have exceptions to the penalty if the house is sold,” says Meyer.

If you are unsure of the terms, ask your lender if prepayment penalties are part of the loan and show you where the relevant details are in the documents.

Some lenders explicitly advertise as a benefit that their products don’t charge prepayment penalties, so if you’re trying to avoid the risk of paying these fees, you might consider applying to one of these lenders.

When is a prepayment penalty worth the cost?

There’s almost never a good time to pay a prepayment penalty, Green says. But there are situations where you might not have a choice.

“When you have to sell, you have to sell,” he says. “At times like this, all options stink.”

So, you may have to pay the penalty to move on under such circumstances.

Meyer says paying a prepayment penalty can make sense if you analyze the numbers and see that refinancing at a lower rate saves you money even after factoring in the prepayment penalty. Another situation where paying the penalty can pay off is when you have a highly valued property and want to withdraw cash for another property purchase, which Meyer says is a common strategy in investing. rental real estate.

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