When you first apply for a mortgage, you might not give too much consideration to the prepayment penalty – but you probably should. If at any point in the future you decide to refinance early for reasons including taking advantage of a lower interest rate or selling your home, it’s important to understand how much you would have to dish out if you are ever slapped with this penalty, as well as when such a payment would need to be made and what circumstances warrant such payment.
What Exactly is a Prepayment Penalty?
Basically, a prepayment penalty on a home loan requires you to pay an extra fee if you decide to pay off your mortgage early. However, it’s important to define what exactly “early” is considered to be, which will be spelled out in detail in your mortgage documents.
The prepayment penalty is already a part of your mortgage package. It will be stipulated on the mortgage along with its associated interest rate, and terms and conditions in the loan documents. Lenders are not permitted to add it after the fact without your written permission.
Depending on your exact home loan, you could be faced with a prepayment penalty if you sell our home or refinance your mortgage before a certain date has come and gone, which is usually two or three years after the mortgage initially takes effect. However, some home loans set this time period to as much as 10 years. Not only that, some prepayment penalties might be required to be paid only in cases of an early refinance, and not with the early sale of a home.
Generally speaking, the prepayment penalty is either expressed as a percentage of the mortgage principal balance or a specific number of months interest. However these fees are calculated, they are usually pretty hefty, which is why you need to crunch the numbers very carefully before deciding if a refinance is financially worth it.
Do the Math Before Refinancing
Sometimes the fine paid is a lot less than the money you can potentially save with a lower interest rate on a new mortgage. On the other hand, the penalty could very well be a lot more than what you would potentially save with a lower rate. That’s why it’s important to do the math before making this decision.
For instance, if you pay a $5,000 prepayment penalty right now to break your mortgage, but save $75,000 over 20 years by refinancing, it would be well worth it. This is especially true if you are planning on staying in your home for the long haul and are not planning another move any time in the near future.
On the other hand, a $5,000 prepayment penalty would not be worth it if you’re planning on moving in a couple of years before you’re able to take advantage of the full savings potential of refinancing your mortgage.
Can You Get Away Without Paying a Prepayment Penalty?
If you want to refinance your mortgage before the penalty time period expires, there’s little you can do to avoid a penalty. If it’s in the contract that you signed, you’re bound to it, as well as all other stipulations on the document. That’s why it’s imperative that you go through the documents very carefully before signing at the very beginning.
As such, there aren’t really many options when it comes to avoiding an existing prepayment penalty. Your best bet is to wait for the penalty to expire and to identify when your prepayment penalty is going to expire.
You could also see if your current lender will allow you to dodge the prepayment penalty of you refinance with them; however, this is not a sure shot. Not only that, the lender will likely require a prepayment penalty on your new mortgage too.
The Bottom Line
Prepayment penalties aren’t exactly an attractive component of a mortgage package. Depending on the situation, it might not make mathematical sense to refinance early if the penalty won’t be recouped at some point. Having said that, this penalty fee could be worth it in the end if your calculations show significant savings over the course of your mortgage. Make sure to crunch the numbers, and work with a seasoned mortgage specialist who can help you figure out the best path to take.