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Avoid Mortgage Prepayment Penalties in 2022

You’re probably puzzled by the term mortgage prepayment penalty.  After all, why should you be penalized for paying something in advance when it almost always benefits the entity receiving the payment? 

This is a term to be aware of while looking at mortgages and deciding what sort of mortgage is best for you, as a mortgage penalty can be buried in mortgage contracts or very confusing when being calculated.

That’s the problem about mortgages, prepayment seems to be a negative or punitive measure rather than doing the right thing with your money.  

By understanding a mortgage penalty now, you’ll be better prepared to go into your mortgage search and eventual contract with more knowledge and tactics for selecting the ideal mortgage lender for your needs.

 

What is a Prepayment Penalty?

A mortgage prepayment penalty is a cost charged by some lenders when you pay off your mortgage loan early in full or in part. The penalty cost encourages borrowers to repay their principal over the course of the mortgage, allowing mortgage lenders to receive interest that accrues.

It’s worth noting that it usually doesn’t kick in if you make a few additional payments here and there to pay down your principal faster; most surrey mortgage brokers allow consumers to pay off up to 20% of their mortgage balance each year. However, when refinancing, selling, or otherwise repaying a considerable portion of a debt, a mortgage prepayment penalty usually applies.

 

What is a Prepayment Privilege?

A prepayment privilege refers to the extra money you can put toward your mortgage over and above your monthly payments without incurring a penalty.

You can use your prepayment privileges to:

  • Increase your monthly payments by a specific percentage.
  • Make one-time lump-sum payments up to a particular amount or percentage of the original mortgage amount

The ability to make prepayments varies per lender. Check the terms and conditions of your mortgage deal to find out:

  • If your lender permits prepayments
  • When your lender permits prepayments
  • If there is a minimum or maximum amount you can pay in advance
  • What charges or penalties are involved
  • If there are any other concerns

Most lenders impose an annual limit on the number of prepayments that can be made. A prepaid sum cannot usually be carried over from one year to the next. This implies you can’t normally add the money you didn’t utilize in past years to this year’s budget.

 

Why Do Lenders Charge Prepayment Penalties?

The majority of people you borrow money from want it back as soon as possible. However, here’s why mortgage lenders refuse to do so.

The lender bears more risk than the borrower during the first few years of a mortgage term. This is due to the fact that most borrowers haven’t put down a considerable amount of money in comparison to the house’s value. 

That is why lenders charge you “interest,” which is a form of risk management. If you pay off the mortgage right away, they lose all of the interest fees that were included in the mortgage as an incentive to grant you, the borrower, a mortgage in the first place.

That’s why many lenders include the mortgage penalty in the first place: they use it to market lower interest rates, knowing that they’ll make up the difference over the life of the mortgage, or to receive a prepayment penalty if you pay off your mortgage before they’ve recovered their costs.

 

How Much Will I Pay?

Prepayment penalties vary in cost, as one might expect. There are, however, some common models for calculating penalty costs:

  •  Percentage of remaining mortgage balance: If the mortgage is paid off within the first 2 or 3 years, they charge a penalty fee of a modest percentage of the outstanding amount, such as 2%.
  • X number of months’ interest: In this case, you just pay a total of a specified number of months’ interest, such as 6 months’ interest.
  • The amount is fixed: The lender enters a fixed amount, such as $3,000, for repaying a mortgage within the first year. (This is a term that isn’t commonly used in mortgages.)
  • Sliding scale based on length of the mortgage: The penalty is 2% of the outstanding principal balance if the mortgage is paid off in the first year, and 1% of the outstanding principal balance if the mortgage is paid off in the second year.
  • Interest Differential – The interest rate differential is the difference between the interest rate and our posted rate on the prepayment date for a mortgage with a term similar to the time remaining in the term and having the same prepayment options as the mortgage less your rate reduction. 

Interpreting Your Mortgage Contract

You should read the fine print as you would with any financial transaction. In this instance, you’ll need to figure out if your mortgage contract contains a prepayment clause and how to interpret the repercussions of triggering the fee.

How Do I Check for a Prepayment Clause?

The good news is that lenders have to disclose prepayment penalties, as well as monthly fees and other mortgage terms, under the law. As previously stated, you should study the “fine print” – in this case, the mortgage estimate or the documentation you’ll sign at closing, where it’ll be found in the addendums and/or disclosure documents along with all the other terms of your mortgage loan.

It’s fine to ask your lender if they charge a mortgage prepayment penalty, and if they do, ask them to show you where you can see the information in the documentation. If you already have a mortgage, you can check your monthly billing statement for details, since they should be included.

 

Learn What Will and Won’t Trigger the Fee

As previously stated, paying a few extra installments will not trigger the mortgage prepayment penalty fee. However, there are situations when you should be mindful that this will happen.

It’s important to understand that there are two types of prepayment penalties:

Be aware of the type of mortgage prepayment penalty that comes with your mortgage when you read through your Mortgage Estimate and contract, just in case something happens and you decide to refinance and/or sell.

If you’re confused, ask your mortgage lender to guide you through the arithmetic as it pertains to your type of mortgage prepayment penalty, mortgage amount, amortization, and interest rate before signing the documents.

mortgage prepayment penalty

 

What to Do with a Prepayment Clause

Do you have second thoughts about paying another fee? You should – after all, no one wants to pay for something they don’t need, especially when they believe they are being prudent with their money. Before you sign your mortgage contract and agree to the mortgage penalty you should take certain factors into account.

 

Run All the Numbers

Even if you don’t think you’ll ever have to pay the penalty, it’s a good idea to be aware of the fees in case you do. In reality, if the charges are excessive, it may be the difference between choosing a mortgage with a prepayment penalty and one without.

Find out what kind of prepayment penalty your mortgage has and compare the cost of living past the penalty date against the cost of paying off your mortgage early and avoiding the penalty. 

Each homebuyer must decide which path is best for their unique financial circumstances.

 

Should I Sign?

While nothing can guarantee that you won’t sell or refinance your home, these questions can help you assess the possibility, and hence how concerned you should be about a potential mortgage prepayment penalty:

  • Do you intend to sell or refinance your house in the near future?

If you know you’ll be in one location for an extended period of time (as much as anyone can be sure, of course), the penalty will not apply to you. You’re also unlikely to refinance if you already have a low-interest rate.

  • How important is it for you to be able to pay on time?

If long-term debt causes you distress, look for mortgage lenders who don’t charge a prepayment penalty, just in case you get a windfall and want to pay it off all at once. Just keep in mind that you’ll miss out on the mortgage interest deduction if you do this, so consider all of your options.

 

Prepare to Negotiate

You might try to negotiate a reduced cost if you opt to stay with your lender and the mortgage with the penalty. After all, even if you want to stay in your new house for a long time, it may be worthwhile to attempt bargaining to reduce your risks in the event that something unexpected occurs.

You can always try to get it withdrawn from the contract; inquire with your lender about waiving the cost. If they agree (which is uncommon, to be honest, but always worth a shot), get it in writing. You can also request a quote from your lender without incurring any fees, however, keep in mind that this may result in an increase in your interest rate.

Finally, look for mortgage lenders who don’t charge mortgage prepayment penalties, as this will save you time and money in the long run.

 

How to Avoid a Prepayment Penalty

Sometimes accepting a prepayment penalty may not be your best option for minimizing your financial strain. Yes, you can try to negotiate a lower price, but switching to a new mortgage or lender is the best method to avoid the fee entirely.

Since not all lenders impose the same mortgage prepayment penalty, acquire estimates from a variety of lenders to discover the best deal for you.

Alternatively, seek lenders like Freedom Capital who advise about prepayment penalties.

Does this sound like something you’d like to learn more about? Get started on your home purchase or refinance right away and enjoy the peace of mind that comes with knowing you’ll never be charged a prepayment penalty, no matter how your financial position changes.

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