The Hidden Cost of Prepayment Penalties

What is a prepayment penalty, and how does someone know if they have a prepayment penalty condition on their loan?

A prepayment penalty is a clause in the mortgage contract that states the lender may assess a penalty if the borrower significantly pays down or pays off the mortgage before the term of the loan.

Typically, prepayment penalties occur during the beginning of the loan and also during a time when interest rate is fixed for a set period. There’s often a section in the signed note that lists the prepayment penalty clauses. That section spells out specifically what the prepayment penalty is and whether it’s a percentage or fee in a set period of months that the lender can assess the penalty.

If there is a prepayment penalty on your loan, what is important for you to know?

There are two things to know about loan prepayment penalties – the cost and your options.

There are three common cost approaches to prepayment penalties.

Step down: It starts as a five percent fee in the first year, four percent in the second year and so on until you get to zero percent after the fifth year. Normally, that is in conjunction with a five-year fixed interest rate.

Percent balance: Typically, it’s two percent of the principal balance of the loan.

Straight fee: While not as common as step down or percent balance, it’s a straight dollar amount associated with prepaying the loan early.

Let’s review a borrower’s options for prepayment penalties.

You can ride out your current interest rate. There are no costs associated with this option.

Refinance with your existing lender. Sometimes, your lender might consider waiving or reducing the prepayment penalty.

Refinance with another bank. Run the numbers first to make sure it's cost effective for you.

Ask the refinancing lender if they have any creative solutions to help with the prepayment penalty. Lenders may be willing to help new borrowers with the penalty fee.

A prepayment penalty is a true cost to the borrower. When you’re considering interest rates and there is a prepayment penalty, understand those associated penalty costs. Typically, a prepayment penalty adds a premium to the rate because it limits your flexibility if you’re locked in on terms and rates’

Since we don’t know what the future holds, a prepayment penalty could limit your borrowing capacity moving forward. When you’re reviewing your loan documents, if you have a prepayment penalty, make sure you fully understand it.

Know that you don’t have to accept prepayment penalties. There are lenders who offer loans without prepayment penalties. You also can ask your lender to exclude prepayment penalties.

Understand the true cost of what the prepayment penalty does for you, and also understand that you have options to not include a prepayment penalty in your note.

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AgChoice Farm Credit specializes in providing farm and country property loans and financial services to help our Martinsburg customers confidently reach their dreams.