Prepayment Penalties Aren't Always a Bad Thing.

A prepayment penalty means that if the mortgage is paid off ahead of its normal term—30 years or 15 years or whatever the amortization period may be—then the borrower must pay the lender a predetermined amount of money. Prepayment penalties are a form of mortgage interest. It's interest that you would have paid had you not paid off the loan or refinanced out of it.

When a lender makes a loan with a prepayment penalty, the lender is able to offer a lower interest rate.

Historically, prepayment penalties have been associated with loans for those with bad credit, and many states have banned prepayment penalties altogether. But lenders can offer a prepayment penalty in return for a lower rate if they choose to do so and if the loans are still legal.

For instance, say a 30-year fixed rate is available at 7.00 percent, but if the borrower agrees to take a prepayment penalty, the lender might offer a 6.50 percent fixed rate instead. On a $200,000 loan, that's a difference of $67 per month, or nearly $800 a year. If the borrower has no intention of selling the property and doesn't see the likelihood of lower rates in the future, then why not consider taking a prepayment penalty offer?

Prepayment Penalties Can Be "Hard" or "Soft."

Note that different states may have different definitions of what constitutes a prepayment penalty and can regulate when and if prepayment penalty clauses can be inserted into mortgage loans.

A penalty will apply if the borrower pays off the original note by selling the home and paying off the mortgage, by refinancing the loan and replacing it with another one, or by making extra payments or principal paydowns. Any of these three events can trigger a penalty.

A hard penalty applies if any of these three events happens. If the borrower so much as pays $10 extra toward the note, the penalty can kick in. Some lenders, however, choose to implement a "soft" penalty.

A soft penalty will allow for principal paydowns and does not apply if the home is sold to someone else. It applies only during a refinancing, and it applies for a shorter term. A soft penalty would typically apply only during the first two or three years of the original loan and would be counted toward only 80 percent of the outstanding balance.

That 80 percent rule means that you can make extra payments during any 12-month period as long as those payments do not exceed 20 percent of the outstanding principal balance. If you have a $100,000 mortgage, you can pay extra without any penalty whatsoever as long as you do not exceed $20,000 in extra payments during any consecutive 12-month period. Soft penalties are rather lenient.

A hard penalty will normally be six months' worth of interest. If you have a $350,000 loan and your rate is 8.50 percent, you can expect to pay nearly $15,000 in interest in the form of a penalty to the lender if you refinance or otherwise pay off your loan. Check with your accountant, but as prepayment penalties are mortgage interest, to help soften the blow, that $15,000 could be tax-deductible. Hard penalties are almost always associated with subprime mortgage loans.

A soft penalty on that same $350,000 at 8.50 percent would, first, apply to only 80 percent of $350,000, or $280,000. Now calculate the 8.50 percent on $280,000, and the penalty is $11,900, representing six months of outstanding interest.

Soft penalties are designed to discourage refinancing. They do not hamper a homeowner if the homeowner decides to sell, but are applied only if the homeowner pays off the loan directly or refinances it.

 
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