What to know about a mortgage prepayment penalty and how to avoid it (2024)

Many homeowners dream about paying off their home loans ahead of schedule to save on interest and get one step closer to being debt-free. However, if your mortgage includes a prepayment penalty clause, there can be costs associated with paying it off early. If you want to refinance your mortgage within its first year, for example, you may have to pay the lender as much as 2% of the remaining loan balance.

Luckily, prepayment penalties aren’t very common today, since Congress’s Dodd-Frank Act limited their scope in 2014. Some mortgages — like FHA, VA and USDA loans — aren’t permitted to have prepayment penalties at all, and even when this fee is allowed, it may only be charged within the first three years of repayment.

We’ll walk you through the basics of prepayment penalties, including when they’re charged and how much you can expect to pay.

What is a prepayment penalty?

A mortgage prepayment penalty is a fee you’re charged when you pay off a home loan ahead of schedule. This fee is commonly calculated as a percentage of the loan’s remaining balance but may be assessed as a flat fee or calculated as a certain number of months’ interest.

Your mortgage contract may contain a prepayment penalty clause that spells out the fee amount and the events that trigger the clause. By law, the lender must disclose the fee at closing, and it must also offer you a loan option that doesn’t contain a prepayment penalty.

You may trigger a prepayment penalty if you sell your home, refinance your mortgage early in the loan term, zero the balance of your loan or make a significant lump-sum payment (typically, 20% of your loan balance or more). This penalty isn’t usually assessed if you make a few extra payments a year.

Types of prepayment penalties

• Soft prepayment penalties only apply to refinancing, paying off the mortgage or making a substantial payment. You can sell your home without penalty.
• Hard prepayment penalties apply to refinancing, selling the home or making a substantial payment.

Why do lenders charge prepayment penalties?

Mortgage lenders make money by collecting interest from borrowers. Imposing prepayment penalties discourages borrowers from paying their loans off early, thereby paying less interest.

Example: Let’s say you borrowed a 30-year mortgage for $300,000 with a 7% APR. Over the life of the loan, the lender would collect more than $400,000 in interest charges — they’ll lose out on some of those profits if you refinance the loan with another lender or repay it ahead of schedule.

However, since the Dodd-Frank Act was implemented, prepayment penalties have become increasingly uncommon among the best mortgage lenders.

Does my mortgage have a prepayment penalty?

The best way to determine whether you’ll be charged this fee is to check your mortgage contract. If you have a fixed-rate, non-government-backed, qualified mortgage (QM, definition below) that was originated in 2014 or later, you may have a prepayment penalty clause. Other mortgage types don’t allow this fee.

Generally, here’s what you can expect:

Before 2014, lenders could add prepayment penalty clauses to mortgage contracts — and often would if they assessed a borrower to be likely to refinance quickly. If you borrowed your mortgage before Jan. 10, 2014, the only way to know if you have a prepayment penalty clause is to read your contract or call your loan servicer.

As a response to the 2007-2008 financial crisis, Congress passed the 2010 Dodd-Frank Act, which put several consumer protections in place, including new rules around prepayment penalties. The law went into effect on Jan. 10, 2014 — mortgages originated on or after that date may only contain prepayment penalty clauses if they are qualified, fixed-rate loans.

Qualified vs. non-qualified mortgages

A qualified mortgage (QM) is a loan with strict underwriting criteria. QMs are prohibited from having risky loan features, like balloon payments, negative amortization or interest-only rate structures. The maximum term for a QM is 30 years, and upfront fees are limited. Most conventional mortgages are “qualified.”

A non-qualified mortgage doesn’t meet these standards — but can still be a safe option. Lenders still verify your credit history and assets but aren’t bound by the same strict criteria. For example, if you’re a freelancer and your income is unpredictable, you may not be eligible for a QM, even if you can reasonably afford the loan. A non-QM opens a path to homeownership for borrowers who wouldn’t otherwise be eligible.

However, because non-QMs are riskier, they often come with higher interest rates. These loans aren’t eligible to be sold to Fannie Mae or Freddie Mac, the government-sponsored entities that guarantee most mortgages to lessen lenders’ risk and improve their ability to continue creating new loans.

How much are prepayment penalties?

The amount of your prepayment penalty and how it’s calculated vary by mortgage origination date and lender. Some lenders charge a fixed amount, while others charge a certain number of months’ interest or a percentage of your loan balance. Your mortgage contract will detail the specifics.

Since Dodd-Frank became law, mortgage prepayment penalties can only be charged during the first three years of repayment. The penalty amount is capped at a certain percentage of your loan balance:

• First year: 2%
• Second year: 2%
• Third year: 1%
• Fourth year and beyond: Not permitted

Prepayment penalty example

You owe $200,000 on a mortgage you signed 18 months ago and want to refinance to a new loan at a lower interest rate. Your lender charges 2% of that balance as a penalty, or $4,000.

Is that cost worth it? It depends. Let’s say you can shave $200 off your monthly mortgage dues by refinancing — it would take 20 months to break even from your prepayment penalty. If you intend to be in your home much longer than that, the savings will outweigh the costs.

However, a prepayment penalty isn’t the only cost of refinancing. You’ll also have to pay closing costs, which can range from 2% to 6% of your loan amount. If your closing costs work out to 3% of your balance, say, you’ll need to fork over an additional $6,000.

In this scenario, your out-of-pocket costs to refinance the loan total $10,000. With a monthly savings of $200, it’ll actually take you 50 months (or more than four years) to break even. Use a mortgage calculator to determine how much interest you could save by repaying your mortgage early, and weigh those savings against the amount of your prepayment penalty.

Tip: To calculate your break-even point, divide the cost of the penalty (and any other associated costs) with your monthly savings.

How can I avoid a prepayment penalty?

Avoiding a prepayment penalty clause may not always be possible if you want a conventional, fixed-rate mortgage. But there are steps you can take to avoid or lessen the toll of prepayment penalties, whether you’re a homebuyer or homeowner:

Homebuyers

• Shop around. Not every mortgage lender charges prepayment penalties. Compare multiple lenders when you’re shopping for a mortgage — not only can you review available APRs and terms, but you may find a lender that doesn’t impose this fee. You may also consider other loan types, like government-backed loans or adjustable-rate mortgages, which aren’t permitted to include this fee.
• Negotiate a lower penalty. Your lender may be willing to lower the penalty amount or be more flexible with the timeline (for example, only impose the penalty during the first year of your loan). Remember, it never hurts to ask, though any negotiations must be finalized before you close on the mortgage.

Homeowners

• Understand your mortgage contract. For loans originated in or after 2014, penalties are limited to the first three years of repayment. If you got your loan before Dodd-Frank took effect, read your contract carefully to determine the events that can trigger the penalty and the amount you’d owe.
• Time your home sale or refinance strategically. If your mortgage lender can’t impose a penalty past the three-year mark, wait until the fourth year of repayment or beyond to sell or refinance your home. If you want to make an extra lump-sum payment that exceeds 20% of your balance, consider splitting the payment across multiple years to avoid triggering the penalty.

Is repaying my mortgage early worth it?

Paying off your mortgage early can save you thousands of dollars in interest charges — money you can put toward other financial goals. Even if you’ll face a prepayment penalty, repaying your loan early or refinancing to a lower rate may still be worthwhile (pending the break-even arithmetic explained above). Before repaying your mortgage early, ask yourself:

• Will the savings outweigh the costs? If you can snag a significantly lower interest rate on a mortgage refinance, the long-term savings could surpass any penalty you’d face. Similarly, if you get a fantastic offer on your home, selling it at a high price could more than make up for your mortgage prepayment penalty.
• Will I be left short on cash? If you deplete your emergency fund, you might be unable to manage unplanned expenses and need to borrow at a higher rate (via credit cards or personal loans, perhaps) to cover them.
• Can I get a better return on my money by investing elsewhere? If you receive a large sum of cash (like an inheritance), consider whether you’d earn a higher return by investing that money in the stock market or in another asset. If you have a low mortgage rate, you may find that a high-yield savings account could be a better way to make your money work for you. Compare the APR of your mortgage to the potential APY of a savings account to see the opportunity costs.

“Borrowers should calculate the potential savings from paying less interest against the cost of any prepayment penalty to determine if early payoff is financially beneficial,” said Carl Holman, communications manager at A&D Mortgage.