Avoiding Mortgage Prepayment Penalties

Mortgage prepayment penalties are one way that a bank or lender can get extra money from you. A mortgage prepayment is when you pay off your mortgage early (either with another mortgage or with cash funds), before the term of your mortgage is up. It can also be accomplished by adding on extra money to your payments to pay off the principal of your mortgage faster. Prepayment penalties are funds that your bank requires you to pay in order to pay off your mortgage early. Keep in mind, by paying off your mortgage early, the lender is losing thousands of dollars in interest payments from you – which are why mortgage prepayment penalties are in existence.

Not all mortgages have prepayment penalties but this is definitely one of the questions you should ask before you sign on the dotted line. It’s best to ask the lender direct questions about mortgage prepayment penalties in a variety of situations such as refinancing your mortgage or making extra payments.

Of course the best thing to do as a homeowner is to avoid prepayment penalties all together – ask the lender to allow you to pay the balance on your mortgage early. If they won’t, see if you are allowed to make extra payments on your mortgage – some lenders will allow you to do this, but only to a certain amount each year. This can either be the amount of payments, percentage of the principal that they’ll allow you to pay, or total amount of money put down.

The reasons you want to keep your options open to pay off your mortgage early are many. Primarily it’s because no one knows what the future holds. What if the interest rates drop two per cent next year? You’d want to refinance your mortgage to save money on the interest without a penalty, otherwise with the penalty involved, it may not be worth refinancing. Other reasons include rapid income growth, such as with a job promotion, or an inheritance or lottery win that you would want to use to pay down your mortgage.

Prepayment penalties are different from lender to lender, however typically they are something like six months of interest on 80 per cent of the mortgage principal. A seven per cent interest rate on a $200,000 mortgage is a $5,600 penalty. With that kind of expense, refinancing becomes an expensive proposition. It may not be worth the effort.

If you already have a mortgage that has a prepayment penalty, you may still be able to fix the situation in some cases. If you are refinancing with the same lender and perhaps including other debts into new loans, you may be able to ask the lender to reduce or eliminate the penalty (basically for keeping your business with them). You’d be surprised at how willing lenders are to negotiate the prepayment penalty if they’re going to lose your business over it. If your lender does allow a reduction or elimination of the prepayment penalty, ensure your new mortgage doesn’t have a prepayment penalty.

Prepayment penalties on mortgages are a way for the banks to get some of the money that they’re losing from you in interest payments for the rest of your loan term. The interest payments are what line the banks coffers, and without it, there wouldn’t be money to loan to others or run the institution (or have a profit margin). So, in some cases, you’ll find lenders unwilling to move on the prepayment penalties on mortgages.

Consider this – if you do take out a mortgage today at 8.5% interest and in eight months time, the interest rate decreases to 5.5% (a 3% savings) you would immediately want to run out and refinance your mortgage. A 3% saving in interest, over the life of your mortgage term is a considerable saving – tens of thousands of dollars. Well, that tens of thousands of dollars was money the bank was counting on as their ‘income’ from loaning you the money to purchase your home. Now, with you wanting to refinance they’re going to lose this money so they want to at least get “some” of it, right? Well, to the lender some of the money is better than none at all (hence why so many lenders are adamant about maintaining a prepayment penalty on mortgages). They apply the penalty to your mortgage and get their few thousand dollars and they’re happy – at least, happier than they would’ve been with nothing, but not as happy as having all the interest you would have paid.

Consider refinancing with the same lender – ask them to renew your mortgage with new terms. A 3% saving to you is a lot of money, but losing your business is a lot of money to them, even if there is a prepayment penalty. The lender would likely have more money in their coffers if they refinanced your loan at 5.5% than have had you to go somewhere else with your business, even if you did pay the prepayment penalty.

If you are absolutely stuck with a prepayment penalty on your mortgage, you’ll have to consider how long you’d have to have your new mortgage at a lower interest rate to ‘pay’ for the penalty you paid. In some cases, it’s only a few months while in others it’s a couple of years. Again, the decision is yours, and should be based on the interest rate you received, if you’re willing to live with it, the home and your mortgage terms, until the new mortgage has paid for the penalties you paid to get it.

The best answer is always to talk to your lender and find out what their policies are – if you have good credit, you can likely find a lender that will give you a new mortgage with no prepayment penalties.