A prepayment penalty on a mortgage is not as common as it used to be, but it still exists on certain loans. The 2010 Dodd-Frank Act limited the loans which can have this penalty. However, because they can still exist, it is important to know you can avoid a prepayment penalty in order to save yourself money and headaches in the long run.
First, it helps to understand the definition of prepayment penalty. This is a fee the lender may charge if you were to pay the loan off before a specified period. The designated period depends on the lender and the type of penalty they assigned to your loan. Today, a lender’s only option is a 3-year prepayment penalty.
Which Loans can Have a Prepayment Penalty?
According to the new Dodd-Frank Act, only Qualified Mortgages may have a prepayment penalty. This means only mortgages which do not have negative amortization, interest-only payments or a term which exceeds 30 years. These guidelines are in place to ensure lenders only give out loans to people who can afford them. For example, a borrower may be able to afford an interest-only mortgage now because they do not have to pay the principal. When the principal becomes due, however, the payments may become unaffordable. If they have a prepayment penalty clause on the loan, they may feel stuck in the loan and end up defaulting and losing their home. This is what the Dodd-Frank Act tries to avoid.
In addition to the need to be a Qualified Mortgage, lenders need to ensure the loan’s APR will not increase after the borrower closes on the loan. This is the case with fixed-rate loans only. They also need to make sure the loan is not considered a high-priced loan. This means loans which have an APR higher than the Average Prime Offer Rate. If a loan meets all of these requirements, it may have a prepayment penalty if the lender so chooses.
Prepayment Penalty Requirements
In addition to the above requirements, prepayment penalties may not be any of the following:
- Exceed 3 the first 3 years of the loan term
- A prepayment penalty amount which exceeds 2% during the first 2 years and 1% during the 3rdyear
How to Avoid a Prepayment Penalty
The easiest way to avoid a prepayment penalty is to read the fine print on your loan documents. By law, the lender must disclose to you the presence of a prepayment penalty. But, you should always ask about it before closing on a loan.
If there is a penalty, talk to the lender about what you can change to avoid it. For example, many lenders will remove the penalty in exchange for a slightly higher interest rate. Oftentimes the increase in the interest rate is not enough to make a dramatic difference in your payment, which means many people can retain their loan approval with the higher payment.
You can also pay other fees in exchange for the prepayment penalty. For example, sometimes paying an origination fee can help the lender make the money they need to make on your loan based on your risk level while removing the penalty. This gives you freedom to do with your loan as you see fit in the future without feeling stuck in the loan for 3 years.
One last way to avoid a prepayment penalty is to shop around. Some lenders charge them and some do not. Even if you live in a state where these penalties are not allowed, if the lender works under federal law rather than state law, you could still find yourself with a penalty on your loan. When you shop around, make sure to ask about the presence of a penalty and if you have any options to remove it from your loan.
Make your Application Attractive
The easiest way to avoid a prepayment penalty is to make your loan application attractive. The riskier you look to a lender, the more likely they are to give you a loan with this penalty clause. The higher your credit score, the more stable your income/employment, and the more assets you have, the less likely it is the lender will stick you with a penalty.
Some lenders also give penalties on loans which they think the borrower will not stay in for very long. If there is a penalty, borrowers are discouraged from selling the home or refinancing the loan in the next 3 years. This ensures the lender the profits from at least the next 3 years of interest. If you do sell or refinance within the 3-year period, the lender still makes money because you will owe the penalty.
It is possible to avoid a prepayment penalty on a mortgage today. In fact, it is easier today than ever before simply because not every loan can have one. If you are not sure, ask your lender – they have to tell you the truth as well as provide you with an option which does not include a penalty. This way you can compare both options and determine which one is right for you now and in the future.