How to Calculate a Mortgage Penalty

During the era of subprime mortgage lending, prepayment penalties were a common feature. Many (but not all) home mortgages contained them. Some prime loans (FNMA, FHLMC) contained them as well. A prepayment penalty is a fee charged to the borrower for paying a loan off early. Legislation has been passed in some states making prepayment penalties on home loans illegal. While most commercial loans carry prepayment penalties, you may not see them on first mortgage home loans for primary or second homes that closed in years 2008 and 2009.

Difficulty: Moderate

Instructions

Things You'll Need:

• Copy of your mortgage promissory note
• Pen and paper
• Calculator
• Calender
• Correct mortgage balance
• Current interest rate

Calculating a prepayment penalty on a mortgage

1. Look through your mortgage papers for the promissory note stipulating how your loan is to be paid. Your note is the instrument that creates the debt on your property. It details the amount of the loan, payments, how the prepayment penalty works and dates that the penalty (if you have one) is in force.

2. Call your lender to obtain the balance as of the date when you plan to pay off the loan. Read your note to see how your prepayment penalty is assessed. One common penalty is the equivalent of six months of interest based on the balance at payoff date. To arrive at that figure, multiply the balance by the interest rate, this will give you one full year of interest. Divide that number by two. That gives you a half year's (six months) interest payment.

3. Another common penalty, which descends over time, is known as 3/2/1. If you pay off your loan in the first year, you pay 3 percent of the balance on the payoff date; in the second year, 2 percent; and the third year, 1 percent.

4. Use your correct balance, and multiply by 3 percent if paying off the loan in the first year. Use the balance times 2 percent if paying off in the second year or use the balance times 1 percent if paying off in year 3.

5. There are other types of prepayment penalties, all of which have an expiration date. The two discussed above are the most common ones. Check your note for dates. If you cannot locate your note, be sure to call your lender. You can bet if you ask for a payoff, the company will calculate it for you, along with the penalty.

Tips & Warnings

• When applying for a loan, always ask if there will be a prepayment penalty. In some states, prepayment penalties are illegal on first mortgages loans. If you are applying for something that is not a first mortgage on a residential primary home or a second home, the penalty could still apply. Since prepayment penalties are considered to be prepaid interest, they are tax deductible. See IRS Publication 530 for this and much more information on deductions you may be not be aware of.
• When you receive a payoff for your loan, do your own math to check behind the lender. Mistakes happen; payoffs have come back with prepayment penalty costs included after the date of prepayment penalty expiration.

References

• IRS Publication 530