A mortgage prepayment penalty allows a lender to collect a penalty from the borrower in case he tries to pay off his mortgage before schedule. While most prime borrowers can escape the prepayment penalty or get a better interest rate when they accept one, sub-prime borrowers are often stuck with a prepayment penalty clause.
Most of the home mortgages are packaged into mortgage-backed securities and are sold to a secondary market. The investors in the secondary market profit from the interest that the mortgages charge but when interest rates fall, most borrowers will try to refinance their loans. This is a risk for the lenders and investors and they, in turn, are willing to offer a better interest rate in return for a prepayment penalty clause which discourages the borrowers from refinancing.
For sub-prime borrowers, even if the interest rates does not fall, timely payment of their mortgage will improve their credit score and consequently will get them a better interest rate two or three years down the road. This is why most sub-prime mortgages carry a prepayment penalty clause. According to the bankapedia website, only 2% of the conventional home loans have prepayment penalties while 80% of sub-prime loans have them.
Most prepayment penalties disappear after an initial period, usually three to five years. Sometimes lenders collect a penalty equivalent to six months of interest; otherwise they charge a percentage of the outstanding loan amount. Most lenders allow as much 20% of the balance as prepayment without incurring a penalty.
Soft and Hard Prepayment Penalties
Prepayment penalties come in two different forms- 'soft' and 'hard'. A soft penalty will apply only when the borrower tries to refinance his mortgage but it allows the borrower to sell his home without incurring a prepayment penalty. Lenders will of course ensure that the home sale was a genuine transaction and not an 'arranged' sale to a friend or a relative to avoid the penalty. A hard penalty means that borrowers are slapped with a penalty even for a home sale.
How Can a Borrower Avoid Prepayment Penalty?
The best way to avoid a prepayment penalty is to make sure that the home mortgage does not have a penalty clause. Borrowers who are not aware of the prepayment penalty are sometimes tricked into accepting one. They come to know about the penalty when they approach another lender for refinancing their home. Always ask the loan officer whether the loan carries a prepayment penalty while shopping for a loan. And just before signing the documents, ask the loan officer to show the clause where it says there is no prepayment penalty.
As per the truth in lending act all borrowers are supposed to receive a Truth in Lending Disclosure Statement (TIL) before signing a home mortgage. It will contain a part where it says "If you pay off your loan early, [ ] may [ ] will not have to pay a penalty". If the 'may' box is checked, it means that the borrower WILL have to pay a penalty. Even though that clause is likely to confuse a borrower, no lender is going to waive a prepayment penalty to a borrower once he has agreed to it.
Sometimes, but not always, a lender may agree to relax the terms of the prepayment penalty if a borrower refinances their mortgage with the same lender.
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