Part 6 of our Mortgage Basics series reviews what a pre-payment penalty is and why it may be part of your mortgage.
A pre-payment penalty means you can be charged a fee for paying off the loan before the mortgage term expires. Not all mortgages have a pre-payment penalty, so make sure you ask if the mortgage will contain this fee.
Normally, a pre-payment penalty only applies if you pay-off the entire mortgage balance because you either sold your home or are refinancing it within a specific number of years. Usually, the time frame is around 3 to 5 years. Sometimes the penalty can apply if a large amount of the mortgage is paid off. However, paying a little extra on the principal in small chunks over time does not apply, but it is always advisable to check with the lender – a qualified mortgage broker or agent should know this as well.
If your loan will have a pre-payment penalty, take the time to understand the circumstances under which you would have to pay. Ask your lender or mortgage broker/agent to provide a quote for a similar loan that does not carry a pre-payment penalty.
There are two types of prepayment penalties, or “prepay”: A soft-prepayment and hard prepayment penalty.
A “hard prepayment penalty” is charged regardless of whether the borrower (you) sells the home or refinances the mortgage. This makes it difficult for the borrower to sell or refinance earlier than expected, and if before the specified time-period agreed to in the mortgage.
A “soft prepayment penalty” is different. This provision waives the fee if the borrower sells their home, but if the mortgage is refinanced the borrower will be subject to the pre-payment penalty, within the terms as defined in the loan agreement.
Why were prepays implemented?
Prepayment penalties were created to protect lenders and their investors who rely on years of interest payments to turn a profit. Early payoffs result in less interest which equals less profit.
Why take a loan with a prepay?
The short answer is that the mortgage may come with a lower interest rate. If a borrower is certain they are getting the lowest possible interest rate and are going to own the home for a long enough time, a loan with a prepay may make sense. It is a very good idea to discuss your situation in detail with your mortgage broker or agent so that they can match you with an appropriate mortgage product.
Pre-payment penalties are a fee for paying off a large part, or the balance, of a mortgage before a specified amount of time. Mortgages with a prepay may offer lower interest rates. A prepay is designed to protect the lender.
Under the Truth in Lending Act, a borrower may exercise their “right of rescission”, which basically allows the borrower to back out of a mortgage within 3 days. Ask your lender or broker to verify the period of time. Your attorney should also advise you on this.
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You may also read the next article in our mortgage basics series, “Standard Mortgage Forms“.