Prepayment penalty is a term we hear often, but how much do we actually know about it? In this article we will take a deep dive into the meaning of prepayment penalties and provide you with a quick way to determine the cost.
What is a Prepayment Penalty?
A prepayment penalty, also known as “prepay”, is a clause in a mortgage contract that says if the mortgage is paid off within a certain time period a penalty will be assessed.
This clause is viewed as an agreement between a borrower and a bank or mortgage lender that regulates what the borrower is allowed to pay off and when. Commonly, most mortgage lenders allow borrowers to pay off up to 20% of the loan balance each year.
Paying off a mortgage early can happen in a variety of ways. Selling a property is one way to pay off the loan in full – and typically, the most common.
However, you can also choose to refinance your mortgage loan, which means that you are effectively paying off the initial mortgage by replacing it with a new mortgage agreement, or, you can also hit the prepayment penalty by making a one-lump payment exceeding the 20% mark in one year, as well.
Types of Prepayment Penalties
There are two types of prepayment penalties: “soft prepayment penalties” and “hard prepayment penalties.” A soft prepayment penalty allows a borrower to sell their property at anytime without penalty, but if they choose to refinance the mortgage, they will be subject to a prepayment penalty.
A hard prepayment penalty is the tougher of the two where a prepayment penalty is issued whether a borrower chooses to sell their property or refinance their mortgage. This type of penalty gives the borrower no option of evading a prepayment penalty if they were to sell their property quickly after obtaining the mortgage.
Prepayment Penalty Specifics
You may be asking yourself, “Why do banks or mortgage lenders have prepayment penalties?” The answer is rather simple… Prepayment penalties were created to protect lenders and investors that rely on years of lucrative payments in order to make a profit.
These are common in difficult economic climates and situations where a borrower is likely to refinance a subprime mortgage.
Why Lenders Use Prepayment Penalties
When loans are paid off quickly, whether by a refinance or a sale, less money than originally anticipated will be made. Prepayment penalties are essentially a way for those with an interest in a borrower’s mortgage to ensure that they get something back, regardless of how long the mortgage is kept before being paid off.
Banks or mortgage lenders also use prepayment penalties as a way to lure buyers with low rates while locking in their profits. The idea is that banks would lower their rates ever-so-slightly but demand that buyers sign a contract to pay a penalty if they paid off their mortgage in a set period of time, usually between three and five years.
Costs of a Prepayment Penalty
How much does a prepayment penalty cost? Although it can vary depending on each mortgage contract, a prepayment penalty is often 80% of six months interest because the lender typically allows the borrower to pay off 20% of the loan balance each year.
The six months interest is the interest-only portion of the mortgage payment the borrower secured when they took out the mortgage. For example, if a borrower has a mortgage rate of 6.5% on a $500,000 loan amount, their interest-only payment comes out to $2,708.33 per month.
Multiply that by six months, and take 80% of the total to get the prepayment penalty cost of $13,000. The prepayment penalty is typically set between 2% and 4% of the total loan.
Where to Find Penalty Information
It is important for a borrower to check their contract or mortgage papers to determine if they have a prepayment penalty and what that penalty is. Lenders are required to disclose prepayment penalties at the time of closing on a new mortgage.
This is usually found on “Prepayment Disclosure” or “Prepayment Penalty Disclosure” documents. By reading the fine print, a borrower should be able to determine if the prepayment penalty is fixed or based on a sliding scale that decreases the longer that the loan is held. Without any disclosures, such penalties can’t be imposed.
How to Avoid Prepayment Penalties? Defeasance.
Defeasance is a complex process to repay a commercial real estate loan early. It is the substitution of collateral for real estate collateral. Instead of paying cash to the lender, this alternative allows the borrow to exchange another cash flowing asset for the original collateral for the loan.
Because loan-holders are expecting a certain rate of return from your commercial loan, you are prohibited from engaging in defeasance during the first two years after your loan’s origination. Learn the specific process of defeasance here.
