What Is a Prepayment Penalty?

What Is a Prepayment Penalty?

A prepayment penalty is a fee charged by a lender when a borrower pays off a loan -- or a significant portion of it -- earlier than the scheduled term. Prepayment penalties compensate lenders for the interest income they lose when a loan is paid off ahead of schedule.

Types of Prepayment Penalties

A hard prepayment penalty applies any time the loan is paid off early, including through refinancing or sale. A soft prepayment penalty applies only if you refinance, not if you sell. A step-down penalty decreases over time -- for example, 3% of the remaining balance in year one, 2% in year two, 1% in year three, none thereafter.

How the Penalty Is Calculated

Percent of balance: $180,000 outstanding x 2% = $3,600 penalty. Six-month interest method: ($180,000 x 6% / 12) x 6 = $5,400 penalty. The exact method is set by your loan note, not a universal formula.

Prepayment Penalties on Mortgages After 2014

The CFPB's Qualified Mortgage (QM) rule significantly restricted prepayment penalties on consumer mortgages. Most conventional conforming mortgages originated after 2014 have no prepayment penalty. Higher-priced mortgage loans cannot have prepayment penalties at all under QM rules.

How to Check for a Prepayment Penalty

Review your loan note and Truth in Lending disclosure for prepayment penalty language before signing. The Loan Estimate and Closing Disclosure must both disclose whether your loan has a prepayment penalty. If you are unsure, ask your lender directly before the loan closes.

Common Prepayment Penalty Mistakes

Assuming every loan today is penalty-free. Most qualified residential mortgages are, but some non-QM loans, investment-property mortgages, and personal or auto loans still carry them.

Confusing a prepayment penalty with rate-lock or origination fees. Those are charged at loan origination regardless of what happens later. A prepayment penalty only triggers if and when you pay the loan off early.