Some mortgages have a clause which states that if the mortgage is paid early, there will be a penalty against the borrower. This is known as a “prepayment penalty” and is often used by lenders to prevent people from mortgage hopping (jumping from one lender to another) in an attempt to lower interest rates. In this regard, prepayment penalties work well; however, with so many people trying to refinance their existing mortgages for better rates, it has become an issue for some homeowners who may have been paying for years on the same loan. There are ways to avoid prepayment penalties when refinancing, but it takes a little financial savvy to understand the terms used by lenders and whether they are giving you all the facts.
Read your Mortgage Note Carefully
Some prepayment penalties expire after a certain amount of time; others are in place for the life of the loan. Your mortgage will give you these terms, and will also help you calculate the amount of the prepayment penalty—most are expressed in terms of a percentage of the principal balance of the loan. If you have had your mortgage for a long time, in other words, the lender will not charge you as much to prepay it as if you try to refinance a few months after acquiring the loan.
You may also be able to talk to the lender if you have had your mortgage more than five years. Some lenders will waive the prepayment penalty clause in return for guaranteeing a mortgage payoff, and if the lender is a good customer. Although this is a less common approach, it does not hurt to ask your lender to waive the prepayment penalty. This may be more likely to happen if you are doing business with a hometown bank rather than one of the big lenders.
Consider Refinancing with the Same Lender
If you must pay a prepayment penalty, you may be able to avoid it if you refinance with the same lender or one of the lender’s subsidiaries. By keeping your business with the same company, you show good faith and the company may, in turn, waive this fee. May is the key word, not many mortgage lenders work on the same good faith however.
Is it worth Refinancing if I have a Prepayment Penalty?
Assuming you do have to pay a prepayment penalty, you can judge whether the refinance is worth the cost. It is not difficult to figure this cost if you have the information from your mortgage. Here is an example of how to figure this cost:
Perhaps you have a mortgage which provides for a 1% prepayment penalty if you refinance within the first three years of the mortgage, and .5% thereafter. You have owned your home and kept the same mortgage for seven years, so you will be using the .5% figure. Your principal balance is $100,000, so your prepayment penalty will be $500.
With a small prepayment penalty like this one, it is probably a good idea to simply pay the fee and get your refinance so that your interest rate will be lowered. You will likely save at least this much during the first year in interest alone, and be able to curtail your principal far more quickly. In this case, it is much more financially feasible to pay a small fee and reap greater savings down the road.
On the other hand, using the same example, suppose the prepayment penalty was a flat 3%, no matter how long you have had the loan. In that case, your prepayment penalty would be $3,000. By the time you add in your closing costs for the refinance, you may be up to $5,000 or more—which will take you quite some time to pay off if you are only saving $100 or so a month with your new payment. In this case, it might be better to seek a refinance with your current company, if you can get a good interest rate.
However, if your current interest rate is terribly high, you may still save enough with a refinance to justify paying the prepayment penalty. It is up to you to determine how much you will save with a new loan product, and this should be based on how long you plan to keep the house, how high your current interest rate is, and how low a new interest rate you will be paying. It may, ultimately, be worth it to pay the prepayment penalty if you will save thousands of dollars over the next few years with your new mortgage.
It makes sense to examine your new refinance for prepayment penalties, as well. In today’s competitive mortgage market, more and more lenders are getting away from prepayment penalties, so it is not likely that you will be forced to accept one in order to get a mortgage. Tell your potential lenders frankly that you do not want a prepayment penalty with your new mortgage, and see if they will work with you.
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