What is a Prepayment Penalty?

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Have you ever wondered what is a prepayment penalty? Homeowners end up paying a huge amount in interest on their homes from their mortgage payments, so it makes sense to want to pay it off as soon as possible or shop around for lower interest rates. 

However, you do need to be careful when overpaying or changing the conditions of your home loan as both can result in prepayment penalties. So, what is a prepayment penalty and is it worth it? Read on to find out.

What is a prepayment penalty?

A prepayment penalty (also called a prepayment charge or breakage cost) is a monetary penalty that your mortgage lender may have the right to charge you if you break or don’t follow the rules in the original loan agreement. A prepayment penalty fee is often charged:

  • If you pay an additional amount towards your mortgage that is higher than allowed
  • If you transfer your mortgage to a new lender before the end of your current mortgage term
  • If you pay back the entirety of your mortgage before the end of your term (this includes when you sell a home)
  • If you break your mortgage contract

Prepayment fees can be very significant, as in thousands of dollars. So, it’s important that borrowers know the conditions of their mortgage contract and understand how and when prepayment fees may apply and how your lender will calculate them. 

Your lender has to disclose all this information. It should be outlined in your mortgage contract under a prepayment penalty clause, but it’s a good conversation to have with your lender as well when you go over the paperwork and disclosure documents to ensure that everything is clear. 

What does no prepayment penalty mean? 

Many mortgage lenders will allow you to put extra money towards your mortgage with no prepayment penalty. This is also referred to as prepayment privilege and can either be done by increasing regular payments by a certain percentage throughout the year or by making additional lump-sum payments up to a certain amount. 

For example, some types of loans may allow you to increase your monthly payments by 15$. In addition, you could pay up to 15% of your original mortgage amount each year.

Not all lenders offer prepayment privileges, and the rules and amount will vary lender by lender, so this is something you want to make sure you ask about ahead of time. Typically speaking, you are allowed up to a certain amount each year, but that amount is not carried over.

If you are in a situation where you think you might come into a large amount of money and be able to make large prepayments, then it is also worth considering getting an open mortgage. Unlike a closed mortgage, open mortgages have no prepayment fees. You can put as much money down as you want when you want. Of course, in exchange for this flexibility, open mortgages tend to have higher interest rates than closed mortgages. 

How much is a prepayment penalty on a mortgage

So, how much can prepayment penalties cost you? This will depend on several things:

  • Current interest rates
  • How much you want to prepay
  • The number of months until the end of your term

On top of that, the prepayment penalty cost will also depend on your lender and how they choose to calculate the fee. There are two ways for them to do this.

Interest Rate Differential

The first method for calculating prepayment fees is the interest rate differential (IRD). The IRD is typically used when the interest rate on your mortgage is higher than the current interest rate, and you signed your current mortgage contract less than 5 years ago.

To calculate the IRD, a lender will use two interest rates to calculate fees and then use the difference between them as the IRD. 

So, the first interest rate will be either the posted rate when you signed your mortgage OR the current rate/discounted rate in your contract.

The second interest rate will either be the current posted rate for a term with a similar length OR the current posted rate for a term with a similar length, minus the discount you were originally offered. 

So, say you have a remaining mortgage loan balance of $200,000 at 5% with 24 monthly payments remaining. But the lender’s current 2-year interest rate is 6%. This means the IRD is 1%. 

The IRD calculation is:  mortgage balance x differential x months remaining/ 12 months= penalty.

So, in this scenario: $200,000 *1%*24/12= $4,000*

*This calculation is just a guide. You will need to contact your lender for exact payments.

Three months’ interest

The second way in which a lender can calculate prepayment fees is to calculate the fixed amount equal to three months’ worth of interest on the outstanding balance of what you still owe. Again, the lender will choose the highest between the options of three months’ interest or the IRD as your prepayment penalty. That said, some smaller lenders only charge three months’ interest as a prepayment penalty as they’re trying to attract more homebuyers to do business with them.

How to reduce or avoid prepayment penalties 

Paying off your mortgage as quickly as possible is ideal because it will allow you to save thousands of dollars over the years in interest payments. However, paying it off too quickly in a way that leads to you being charged prepayment penalties is also not ideal, as that can also cost thousands of dollars. Here are a few tips to help avoid these hefty fees.

  • Use all of your prepayment privileges –  If you max out your prepayment privileges every year, any prepayment penalties you might have to pay in the future are based on a lower mortgage amount because you will have more equity in the home.
  • Wait until the end of your term to put down a large lump sum – This is especially true if the prepayment fee will be a large amount.
  • Port your mortgage – to port your mortgage means asking your lender if you can take your current rate, terms, and conditions with you when moving into a new home. This means you don’t need to break your mortgage contract.

Finally, when looking for a mortgage, don’t forget to shop around. Different lenders will have different terms and conditions regarding when and how they charge prepayment penalties. Some will be more flexible than others.

Is a prepayment penalty worth it?

So, is a prepayment penalty worth the cost if it can end up being a few thousand dollars?

It might be. It depends on the circumstances of borrowers.

If you have come into a large chunk of money as an inheritance and want to put it down on the home, that could save you even more on interest payments in the long run. 

If the market changes and rates have gone down, then the fees from the prepayment penalty charged for breaking your mortgage to take advantage of the new fees might still be less than the original interest you would have paid in the long run. Similarly, if rates are on the rise, it might be worth it to refinance your mortgage and pay the prepayment penalties to switch from a variable to a fixed mortgage. 

At the end of the day, it comes down to doing the math. A mortgage broker can help you by calculating these fees to show you what you can potentially save by breaking a mortgage, even if it involves paying the prepayment penalty.

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About Hannah Logan

Hannah Logan is a freelance writer based in Ottawa, Canada. She specializes in finance and travel writing and has bylines at Fodor's Travel, O Magazine, and more. She also runs two travel blogs, Eat Sleep Breathe Travel and Ireland Stole My Heart. You can find her on Instagram and Twitter @hannahlogan21.

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