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Basics of Prepayment Penalty and How to Avoid It

By Sadiya Anjum


Prepayment penalty is a common term you may see in mortgage contracts and although they may help secure a loan (especially with a bad credit score), it is best to avoid it. Prepayment penalty is basically a fine that must be paid if the borrower repays the loan before the term period of a loan ends.

Prepayment penalty is usually charged within a specific period of time, after which it expires. Typically this period is 5 years but varies for different loans and lenders. After this period, paying off the loan early does not subject you to a penalty payment. Sometimes even a partial payment of more than 20% of the original loan balance made during a 12 month period (of the penalty period) may subject you to a prepayment penalty. These kinds of clauses vary and are part of the mortgage contract.

The amount of the Prepayment penalty is not fixed and it is usually calculated as interest on a certain number of months or a percentage of the outstanding balance. But it can be as high as 6 months worth of interest calculated on 85% of the outstanding loan balance.

A prepayment penalty may not seem like a big deal if you intend to live in the house for more than 5 years. But circumstances change; you may want to sell your home or refinance with a better interest rate or pay off the loan with your lottery winnings. The bottom line is that it is best to avoid a prepayment penalty.

Most often it is borrowers with bad credit scores obtaining sub-prime loans who get stuck with a prepayment penalty. Since these are high-risk loans, the lender indirectly forces you to continue to do business with him for a certain period of time instead of refinancing or taking your business elsewhere. Sometimes lenders may even offer lower interest rates to people with good credit scores as long as they agree to a prepayment penalty. The tactics are different but unless you are dead sure that the prepayment penalty is not going to hurt you, you should seriously avoid it.

For sub-prime loans, people will have to deal with a prepayment penalty. But remember that everything is subject to negotiation. Ask your lender to remove the prepayment penalty entirely if you agree to buy a few points. Usually buying points helps to reduce or eliminate the penalty. Or at least negotiate on the term period of the prepayment penalty and ask him to bring it down. Alternatively you can ask to reduce the amount of the penalty, or even better negotiate on both aspects term and amount. Since the market is competitive, your lender will want to make sure that you do business with him. Keep this in mind when negotiating; and if his terms are too harsh then just go to another lender.

If you are already trapped with a prepayment penalty and want to get out, there is little you can do. But call your lender to discuss your situation. He may not waive the penalty but if you think of refinancing with him, he may offer some solution. If you are lucky enough to be moving because of your job, employers usually pay for all sales and moving costs. They may cover your prepayment penalty too.

Ideally before you sign on the dotted line you should read the entire contract properly and understand all the clauses. Ask your lender or your attorney to explain any terms and conditions you do not understand. Also remember to shop for lenders before settling for any. Even if you are looking for a sub-prime loan, shopping will help you determine the best loan available for you. So take time before plunging into any mortgage contract.

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