How to Weigh the Costs of Prepayment Penalties

Prepayment penalties are those extra fees that some lenders charge for paying off a loan ahead of schedule, or refinancing. Since banks and lenders make profit off of high interest rates, they make less money when a borrower pays off a debt early. In most cases, a prepayment penalty is not high enough to completely deter one from paying down a loan early, or refinancing. But with some loan contracts, prepayment penalties are steep.

If you are considering making early payments on your mortgage, or you are deciding whether or not to accept a home loan with a prepayment fee, the steps below will help you evaluate the risks.

Difficulty: Moderate

Instructions

1. Before you sign with a lender, read the fine print about any prepayment fees. If you aren't sure, ask your lender to highlight the penalty clauses. If it isn't written, you should request that all the prepayment penalties (or lack of any) be made explicit in the loan contract. That way, if your lender sells the loan to another company or bank, your new lender won't be able to add any extra terms without your knowledge.

2. Next, know that most prepayment penalties are either based on a percentage of the remaining balance, or set at 6 months worth of interest payments. Additionally, the penalty may be waived if you refinance with the same company, or make an early payment on no more than 20% of the balance. Some home lenders may only institute a penalty if you prepay during the first 5 years.

3. Understand that some lenders will reward you with a lower interest rate if you accept a home loan with early payment penalties. Before you accept such terms, assess the likelihood that you will pay off the loan early. Are you going to sell your house, win a settlement, or refinance if the interest rates go down? If so, you must compare the cost of the penalty to the savings.

4. For example, suppose that you take out a 30-year mortgage on $100,000 at a 5% annual rate, with a 2% prepayment penalty. Using a mortgage calculator and amortization schedule, you compute that after 13 years, the remaining loan balance is $71,000, and the amount of interest left to be paid is $32,000.
   
   Since (.02)(71000) = 1420, the prepayment penalty for paying off the balance after 14 years is $1,420. That is far less than $32,000, so you come out ahead by paying off the balance.

5. Suppose that you have a 15-year home loan for $100,000 at an interest rate of 7%, and a prepayment penalty equal to 6 months interest. At the end of 8 years, the amount of interest owed is $19,000, and the next 6 months of interest is $2,400.
   
   In this case, the prepayment penalty is steeper, but you will come out ahead if you pay off the full balance. However, if you make only a partial prepayment, you could actually lose money.

6. Any time you consider making an early payment, use a mortgage calculator and amortization table to compute the amount of interest still owed, and the precise prepayment penalty.