How Does a Mortgage Prepayment Penalty Work?
Many mortgage agreements include a prepayment penalty clause. This means that if the borrower repays the full loan amount within a certain time, she must make an additional payment on top of the outstanding loan value. The penalty is designed to make up for the loss of interest that the bank would have collected had the borrower repaid on the original schedule. A prepayment penalty can affect whether it is financially worthwhile for a borrower to switch to a new mortgage lender offering a lower rate.
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Principle
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A mortgage prepayment penalty is a fee that a borrower must pay a mortgage lender if he wants to pay off the mortgage in its entirety before its scheduled completion date. It can cause confusion as "prepayment" in this context means an early repayment.
Terms
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The precise terms of a mortgage prepayment penalty can vary. The most typical setup is that the penalty applies if the mortgage holder wants to pay off the full mortgage amount within three to five years after taking out the mortgage. The penalty will typically be around 2 to 4 percent of the original loan amount. In some cases the penalty decreases over time.
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Justification
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Mortgage lenders calculate rates based on the interest they will receive over the length of the loan. If a borrower pays off early, the total amount of interest the lender receives will be much lower than anticipated. This can affect the overall balance of the reward a lender gets in the form of interest, and the risk it takes that borrowers might not repay. From the bank's perspective, the prepayment penalty acts as a partial compensation for the lost interest.
Legality
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The legality of a mortgage prepayment penalty is a purely contractual manner. If a mortgage agreement includes a clause for a mortgage prepayment penalty, then the borrower is legally obliged to pay the penalty under the stated circumstances. It is possible a lender would agree to renegotiate the penalty if and when it is imposed, but it is under no obligation to do so. In contrast, a lender cannot impose a mortgage prepayment penalty unless the loan documents specifically allow for such a measure.
Effects
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It might seem that few borrowers would be affected by a mortgage prepayment penalty, simply because -- short of a lottery win -- it's unlikely they'll have enough cash to pay off the full amount so early.
In practice, though, the penalty can be a barrier if a borrower wants to switch mortgage providers: taking out a new loan with a new lender and paying off the original loan in one go. While the hassle of doing this might seem too high just because another lender is now offering a lower rate, it can be a valuable option for borrowers who took out a mortgage with an introductory rate that only lasted for a set period and then reverted to the bank's standard variable rate. In such circumstances a borrower needs to calculate the total savings available by switching lender and then determine if this outweighs the cost of the penalty.
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