What Exactly is a Prepayment Penalty?

A mortgage loan is a commercial financial product. When the lender extends the loan to you, certain calculations are conducted pertaining to the profits the lender expects to generate initially and over the length of the loan’s lifespan. The profit is in the form of interest the lender earns over a period of time. In case you decide to square-off the loan, disengage yourself from the loan, or opt for some sort of mortgage refinancing before the pre-determined repayment period is complete, the lender is not going to be as profitable as they originally calculated. So in order for the lender to recoup a portion of the loss, they levies you with a series of prepayment penalties.

Though you might not have noticed it, you agreed to the clause in your mortgage contract that states if the loan is repaid before the designated period, the lender will impose certain penalties. These clauses are usually mentioned under the Prepayment Penalty Disclosure or Prepayment Disclosure heading.

Calculating Prepayment Penalties

The prepayment penalties are normally incurred on borrowers who want to refinance, sell, or repay the loan within the first five years of the loan tenure. During the first five years of the loan repayment period, interest forms the major component of your monthly payment. The lender makes most of their profit during this period, and after this time your  payments are mostly applied to the  principle. Thus, lenders son’t usually penalize you for opting to prepay the loan after five years.

The prepayment penalty issued by the lender differs from product to product. For instance, certain mortgage products appoint a fixed amount in regards to the penalty, while others calculate it based on various parameters. Most lenders calculate the prepayment penalty as a percentage of the outstanding principal amount.

Weighing the Pros and Cons of Paying a Mortgage Off Early

Of course you are not eager to pay penalties just because you want to refinance your home loan or any loan for that matter. Does that mean you should not prepay the loan or attempt to refinance because of these imminent financial penalties?

Well, in the case of refinancing, if the new mortgage rate is much lower than the first mortgage, it certainly makes sense to pay the prepayment penalty. For instance, by paying a penalty of $4,000, you might be saving $50,000 on a mortgage of 30 years. So, if you can handle that $4,000, this scenario benefits you in the long run. However, just because you have accumulated a cash injection and want to eliminate your burden of debt, paying the prepayment penalty does not always make sense. Since the interest you pay to the lender bestows upon you some mighty tax benefits. If you prepay the loan, this might not be the case any longer.