Borrowers who pay off their loan early (usually within the first few years) may have to pay a penalty
Mortgage lenders calculate the prepayment penalty as either a percentage or fixed amount
Government-backed loans, like FHA loans and student loans, do not have prepayment fees
When people buy a home, they likely need to take out a mortgage, which is repaid over a set period of time. (15- and 30-year mortgage loans are most common.) However, interest payments can easily cost you hundreds of thousands of dollars over the lifetime of the loan, so you might want to save that money by repaying the loan early. Getting ahead of debt is a wise idea, but making a large chunk of payments before the loan term ends can actually result in a fee, called the prepayment penalty. The penalty protects the lender from losing out on the interest generated during the lifetime of the loan when the borrower repays the loan ahead of schedule.
Selling your house or refinancing it — both of which result in using the proceeds to repay the original loan — can also result in a prepayment penalty.
When the penalty happens and how it is calculated depends on the lender. We’ll talk about what types of loans have prepayment penalties, how they work, and what to do if you do want to pay off your mortgage early.
How does a prepayment penalty work for mortgage loans?
The purpose of the prepayment penalty is to protect the lender. When you take out a mortgage, you’re not only expected to repay the principal, but also the interest that accrues. This is how the mortgage lender makes money. (You can learn more about how mortgage interest works here.) Interest can add up to tens or hundreds of thousands of dollars over the lifetime of the loan, so paying the mortgage off early means saving a lot of money on interest.
When you repay the loan early, the lenders won’t receive all the interest you were supposed to pay them over the years as part of your monthly mortgage payments. Prepayment penalties exist to compensate the lenders for losing this money.
The penalty fee only applies if you repay the entire loan balance, or a large chunk of it — and only during a certain period of time. The prepayment penalty usually only applies within the first three to five years after taking out the loan.
There’s typically no prepayment penalty for simply making small extra payments. You can ask your lender or look at your mortgage loan agreement or billing statement to see how much you’re allowed to pay ahead without incurring the penalty fee. For example, the lender might let you make up to 20% in extra payments each year.
Two types of mortgage prepayment penalties
Loan prepayment usually happens when the borrower decides to sell the home, and then repay the loan, or refinance. To refinance a mortgage means taking out an entirely new loan, hopefully with better terms, to repay the old one.
If your lender only charges a prepayment fee when you refinance, but not when you sell your home, then your loan has a soft prepayment penalty.
If you’re required to pay a fee when you repay the loan early after selling or refinancing your home, then that means your loan has a hard prepayment penalty.
What types of loans have a prepayment penalty?
Having no prepayment penalty gives the borrower freedom to pay down as much of their loan as they wish with no negative consequences, like paying fees.
Conventional mortgage loans, on the other hand, may have prepayment penalties. But certain mortgages — like fixed-rate loans and other qualifying mortgages (QMs) without higher-than-average mortgage rates — that originated after January 10, 2014, have to follow certain consumer protection laws. Additionally, any ARM that is otherwise a qualified mortgage cannot have a prepayment penalty. For example, the mortgage broker must provide information about penalties on the monthly billing statement and they must also offer an alternative loan without prepayment penalties.
Personal loans including auto loans may also have a prepayment penalty.
How is a prepayment penalty calculated?
Mortgage lenders ultimately decide how to calculate your prepayment penalty. It may be a percentage of your remaining loan balance or a percentage of several month’s worth of interest, or even a fixed amount.
For example, let’s say you sell your home after two years and the remaining mortgage balance that you repaid early was $469,000. If the prepayment penalty on your loan is 1.5%, then you are required to pay a $7,035 fee.
The federal government sets a limit on how much prepayment penalty the lender can charge for loans taken out after January 10, 2014. The prepayment penalty is limited to no more than 2% of the outstanding loan balance if you prepay during the first two years of the loan, or 1% if you prepay the loan during the third year.
Some states set additional limits as well.
Is the prepayment penalty tax deductible?
Borrowers can deduct the mortgage interest when they file taxes. They might also be able to deduct prepayment penalties, depending on the situation.
For example, when you refinance, you have to pay all the closing costs associated with getting a mortgage, like origination fees. If the prepayment penalty gets rolled into the costs of refinancing, then you may not be able to deduct it. Mortgage interest deductions can also be affected by whether or not the property is a primary residence or rental property. Talk to a tax professional who can better advise you.
Learn more about the mortgage interest tax deduction.
Avoiding a prepayment penalty
The best way to avoid a prepayment penalty is to try to find a loan without one. If you want to sell or refinance your house without paying a penalty, then it might be best to just wait until the penalty period is over. Otherwise, compare the penalty fee with how much you’d potentially save in the long run by selling your house. You can also try to factor the prepayment fee into the sale price, but it may make the house harder to sell.