A prepayment penalty is a certain type of penalty incurred on a borrower in certain cases where they repay a loan before the loan term ends. It incentives the borrower to pay off the loan over the full term, in order for the lender to earn interest on the loan. The penalty is typically a percentage of the loan amount such as 2% or a predetermined number of months’ worth of interest. Prepayment penalties are somewhat common in the world of home loans and mortgages.
Mortgage providers are required by law to inform a borrower of prepayment penalties when closing a mortgage. Usually, this comes in the form of a clause within the mortgage agreement between the borrower and the lender. An educated borrower should ask a lender regarding prepayment penalties early into the discussion to avoid unpleasant surprises. That being said, not every type of loan or mortgage includes prepayment penalties.
Typically prepayment penalties are incurred if the borrower pays off the mortgage in its entirety, early into the mortgage terms usually 3 years since the loan’s origination. They are common in qualified mortgages with fixed rates.
Prepayment penalties are also sometimes used to discourage the borrower from certain behaviors. This includes “house flipping” or selling shortly after buying and refinancing a mortgage at lower rates.
While prepaying a mortgage may inflict a penalty, it will not affect a borrowers’ credit score negatively, like canceling credit cards. Regardless a borrower should check all the clauses in a mortgage contract and be informed before signing.