Prepayment Penalties: Still an Issue?

A prepayment penalty is a fee that mortgage lenders charge if you pay off your mortgage loan too early. You might incur this fee if you refinance your mortgage or sell your home too early in your existing mortgage loan's life.

Lenders might charge this fee to encourage borrowers to hold on to their mortgages for a longer time. After all, lenders make much of their profit from the interest they charge on mortgages. If you pay off your loan too early, you'll cut into these profits.

These fees are rarer today

Fortunately for borrowers, mortgage prepayment penalties are rarer today. Federal laws that went into effect in 2014 place limits on when prepayment penalties can be charged and how much they can be.

According to the federal Dodd-Frank Act, lenders can charge prepayment penalties only on conventional mortgages, home loans that aren't insured by a government body. This means that lenders can't charge these penalties on Veterans Administration, Federal Housing Administration or U.S. Department of Agriculture loans.

The Dodd-Frank Act also says that lenders can charge prepayment penalties only during the first three years of a mortgage. Even if your lender charges this fee,  you won't be charged if you refinance or pay off your mortgage after three years.

Lenders are also limited in how much they can charge. During the first two years of your mortgage, your prepayment penalty is limited to 2% of your mortgage's principal balance. In year three of your loan, lenders can charge a maximum of 1% of your mortgage's principal balance.

Say you want to sell your home after just one year and pay off your mortgage. If your loan's principal balance is $325,000, your lender can charge a prepayment penalty of $6,500, or 2% of your loan's remaining balance ($325,000 x .02 = $6,500).

Say you refinance your mortgage in its third year and your principal balance is $280,000. Your lender can charge a prepayment penalty of 1% of that amount, which comes to $2,800.

Shopping around matters

Most mortgage holders are able to avoid prepayment penalties. While lenders can still charge these, many don't. Before applying for a home loan, shop around with different lenders. Compare the interest rates these lenders charge, but also ask each lender how much it charges in fees. Inquire whether it will charge a prepayment penalty if you pay off your mortgage too early.

Be mindful if you took out a mortgage before 2014. That's when the Dodd-Frank changes regarding prepayment penalties took effect. If you took out a mortgage before 2014, you might face higher prepayment penalties and penalties that kick in even if you've held your loan for more than three years. It's important to research any penalty fees you might face with an older mortgage.

This is just an overview of mortgage prepayment fees. Rules can change quickly, often with little notice, and there are more details that may apply to your actual mortgage. It's best to work with real estate, legal and financial professionals.