Mortgage lenders make money by charging interest. The higher the interest rate, the higher their profit. To guarantee that profit, some lenders charge certain borrowers a penalty if they repay the mortgage early, either by refinancing or by selling the house. However, the Federal Housing Administration, or FHA, prohibits prepayment penalties on the mortgages it backs.
When a lender places a prepayment penalty on your mortgage, it usually does so only for the first several years of the loan. With a fixed-rate mortgage, this penalizes you for selling your home during the period when you are paying the most in interest every month. (The percentage of each monthly payment that goes toward interest declines over time.) With adjustable-rate mortgages, which usually start with a low introductory interest rate, you are penalized for selling before that low-rate period ends and the loan resets to a higher rate. Federal regulations require lenders to disclose all such penalties upfront when you sign the loan papers.
FHA can help you obtain a home loan by guaranteeing to lenders that if you quit making your payments, the government will pay off the loan. FHA doesn't actually lend money; an FHA loan is simply a mortgage it has guaranteed. These loans are an option for people with a marginal credit rating, uneven income, no money for a down payment or something else in their finances that causes lenders to view them as high risk. If they were to get a loan outside the FHA system, such people would be the most likely to have to accept a prepayment penalty. Fortunately for them, federal regulations specifically forbid prepayment penalties on FHA-backed loans. The penalties are also prohibited on loans backed by the Department of Veterans Affairs and mortgages issued by federally chartered credit unions.
There is one circumstance in which you might incur an extra charge for paying off an FHA loan early. When you pay off the loan, the lender is allowed to charge you the interest that would have accumulated on the loan between the payoff date and the time your next payment would have been due, typically the first of the month. Say you sell your house and pay off your FHA mortgage on June 18. Your next payment would have been due on July 1. The lender can charge you 12 days' worth of interest on whatever the balance of the loan was when you paid it off. The Department of Housing and Urban Development has ruled that this charge does not constitute a prepayment penalty; in 2009, the Federal Reserve Board, whose rules require lenders to disclose all prepayment penalties, said it agreed with that ruling.
Legislation introduced several times in Congress has attempted to close the loophole that allows lenders to collect extra interest on prepaid FHA loans. In March 2011, for example, U.S. Sen. Ben Cardin, of Maryland, sponsored a bill he called the "Reduce Excessive Interest Payments Act." As of mid-2011, no legislation to limit the practice had passed in Congress.