A 3-2-1 prepayment penalty, otherwise known as a 3 year stepdown prepayment penalty, charges a 3% fee on the outstanding principal loan balance if the loan is paid off in year 1, a 2% fee in year 2, and a 1% fee in year 3.
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.
Another common step-down structure for a five-year loan term is the 3-1-1, which only penalizes the borrower if the debt is prepaid within the first three years of the term. Many lenders do not impose a step-down penalty in the last 90 days of a loan term.
Dodd-Frank also set limits on the size and timing of prepayment penalties. A fee can only be assessed during the first three years of the loan term. The penalty can be 2 percent of your principal balance within the loan's first two years and 1 percent of your loan balance in year three.
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.
Negotiate To Remove The Prepayment Clause
Ask your lender if they'll waive the prepayment penalty fee. If they agree, get it in writing. You can also ask your lender for a mortgage quote without a penalty, but a mortgage quote without a penalty fee may have a higher interest rate.
A 3-2-1 buydown mortgage means that you have a fixed “step down” during the first three years: 3%, then 2%, then 1%. On the other hand, an adjustable-rate mortgage means you have a low initial mortgage rate that then equalizes to the market rate after a certain period of time.
Experts recommend that borrowers take out a shorter loan. And for an optimal interest rate, a loan term fewer than 60 months is a better way to go.
A 3/1 ARM, or adjustable-rate mortgage, is a 30-year, fully-amortizing mortgage with a low, fixed introductory rate for the first three years. After this fixed period, the rate becomes variable, changing once per year. The variable rate is tied to a benchmark, typically the Secured Overnight Financing Rate (SOFR).
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.
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.
Negotiate with your lender
Some lenders may be willing to negotiate with you to reduce or even remove the prepayment penalty, but you'll need to call and ask. They may be more likely to negotiate if you've made your payments on-time every time.
For Fixed rate mortgages, the prepayment charge will be the greater of 3 months interest or interest for the remainder of the term on the amount prepaid calculated using the interest rate differential. For variable rate mortgages, it is 3 months interest.
Analyzing the 4-3-2-1 Rule in Real Estate
This rule outlines the ideal financial outcomes for a rental property. It suggests that for every rental property, investors should aim for a minimum of 4 properties to achieve financial stability, 3 of those properties should be debt-free, generating consistent 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.
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.
Lenders consider long-term loans riskier and consequently charge higher interest rates for them.
One of the main disadvantages is the higher overall cost of the mortgage. When you opt for a 3-2-1 buydown, you're prepaying some of the interest upfront. While you'll enjoy lower payments initially, you'll pay more interest over the loan life compared to a standard mortgage with the same note rate.
Who Pays for a Buydown? Pretty much anyone involved in the process of buying or selling a home can pay for a mortgage buydown—including the seller, the buyer or even a builder. Sometimes, a seller will offer to pay for a buydown so their listing will have a little icing on the cake.
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'.
You can't prepay, renegotiate or refinance a closed mortgage before the end of the term without a prepayment charge. But, most closed mortgages have certain prepayment privileges, such as the right to prepay 10% to 20% of the original principal amount each year, without a prepayment charge.
The statute prohibits prepayment penalties or other charges for prepayment on any written mortgage contracts where the interest rate exceeds 8%. The prohibition does not apply to loans insured by federal agencies.