A prepayment penalty is a fee that some lenders charge if you pay off all or part of your mortgage early. If you have a prepayment penalty, you would have agreed to this when you closed on your home. Not all mortgages have a prepayment penalty.
Prepayment penalties can be charged in a variety of ways. They may be calculated as a percentage of the remaining loan amount — typically 1 to 2 percent. The penalty could be equal to a certain number of months' interest. Or some lenders may charge a flat fee.
Lenders expect to receive interest income from the monthly payments on any given loan, and when the loan is paid off early, the income is less than expected. To make up for this loss, lenders often require the borrower to pay a fee, a premium, or more colloquially referred to as a “penalty”.
For most fixed-rate closed mortgages, the prepayment charge is usually 3 months' interest or the IRD, whichever is greater.
Prepayment penalties are usually only due within the first few years of the loan, so if you can, try to wait to sell, refinance, or pay off the loan until that time.
Prepayment penalty fee examples
Using a $200,000 home loan balance, mortgage prepayment penalties may be calculated as follows. For 1% of the remaining loan amount: $200,000 X 0.01 = $2,000 lump-sum prepayment penalty.
A prepayment penalty is only allowed during the first three years after the loan is consummated. After three years, a prepayment penalty isn't allowed. (12 C.F.R. § 1026.43(g) (2024).)
Not all states allow prepayment penalties — and no lender can charge one on a loan term over 60 months. But if your contract already has one, there are ways to work around it. Start by getting in touch with your lender and asking for payments to be applied differently. If that doesn't work, consider refinancing.
Even if you plan on staying in your new home for many years, consider negotiating the prepayment penalty in case something changes. You can try to negotiate to remove it from the contract. Ask your lender if they'll waive the prepayment penalty fee. If they agree, get it in writing.
Some of the most common examples include the 3/2/1 and 2/1 prepayment penalties. In the former's case, you would pay 3% of your outstanding loan balance if you pay off your mortgage in the first year. The penalty fee drops to 2% in the loan's second year, 1% in the third year and is eliminated after that.
The prepayment rules alter the timing of deductions for certain prepaid expenses. These rules apply to prepaid expenses that would ordinarily be immediately deductible in full in the year in which they are incurred. Generally, a prepaid expense is deductible over the 'eligible service period'.
Key Takeaways
A prepayment penalty clause states that a penalty will be assessed if the borrower significantly pays down or pays off the mortgage, usually within the first five years of the loan. Prepayment penalties serve as protection for lenders against losing interest income.
Most states allow lenders to impose a fee if borrowers pay off mortgages before a specific date – typically in the first three years after taking out a mortgage. While Alaska, Virginia, Iowa, Maryland, New Mexico, and Vermont have banned prepayment penalties, other states allow them with certain conditions.
Some examples of prepayment include: Purchasing goods or services as prepaid assets: you might purchase office supplies in bulk, for instance, and pay for them upfront. Repaying the interest on a business loan: you might take out a loan, and make an upfront payment to cover the first few months' worth of interest.
You could save interest and free up room in your budget by paying your auto loan off early. There are several options available — including refinancing, paying biweekly and rounding up payments, just to name a few. Confirm your lender doesn't charge a prepayment penalty since the cost could be more than what you save.
The early payoff may disturb their cash flows and reduce overall interest receipts. Additionally, these fines make borrowers stay with the same lending terms, discouraging refinancing or switching lenders too often.
Extra payments made on your car loan usually go toward the principal balance, but you'll want to make sure. Some lenders might instead apply the extra money to future payments, including the interest, which is not what you want.
You may also contact the bank and ask about the prepayment penalty. If you believe the bank should not have charged a prepayment penalty, you can try requesting a refund for the prepayment penalty. You can also file a written complaint with the OCC's Customer Assistance Group.
Let's look at a couple of examples using a loan of $250,000 and an interest rate of 5%. To illustrate another type of prepayment penalty, a sliding scale fee based on the years remaining on your loan would be 2% of $250,000 if you paid off your mortgage in year one or two. That fee would come out to $5,000.
Pre-computed interest requires you to pay more interest at the beginning of your loan than you'll have to toward the end. The penalty for paying off this type of auto loan early can be as high as two percent of your outstanding balance.
1-0 Prepayment Penalty
A 1-0-0 prepayment penalty, charges a low 1% fee on the outstanding principal loan balance if the loan is paid off in year 1, and no prepayment penalty thereafter. The 1-0-0 prepayment penalty option carries the highest interest rate compared to the 5-4-3-2-1 option, typically 0.65%.
Types of payments you can make: Monthly payment. Principal-only payment. Escrow deposit.
If your client already has a mortgage with a prepayment penalty, they can try to negotiate it away. Some lenders may be willing to remove the penalty if the borrower agrees to a slightly higher interest rate. It's worth a try, especially if your client thinks they might want to pay off their mortgage early.