Weighing the Costs of Pre-Payment Penalties

Pre-payment penalties are extra fees that some lenders will charge you for paying off a loan ahead of schedule. Lenders can also charge pre-payment penalties for refinancing. Since banks and lenders make their profits off of high interest rates, they make less money when a borrower pays off a debt early. In most cases, a pre-payment penalty is not high enough to completely deter you from paying down a loan early, or refinancing. But with some loan contracts, pre-payment penalties are steep.

If you are considering making early payments on your mortgage, or you are deciding whether or not to accept a home loan with a pre-payment fees, the guide below will help you evaluate the risks.

Before you sign with a lender, read the fine print on your loan contract. Ask your lender to highlight the penalty clauses. If they aren't written, you should request that all the pre-payment penalties (or lack of any) be made explicit in the loan contract. That way, if your lender sells the loan to another company or bank, your new lender won't be able to add any extra terms without your knowledge.

Most pre-payment penalties are either based on a percentage of the remaining balance, or set at 6 months worth of interest payments. The penalty may be waived if you refinance with the same company, or make an early payment on no more than 20% of the balance. Some home mortgage lenders may only institute a penalty if you pre-pay during the first 5 years.

Some lenders will reward you with a lower interest rate if you accept a home loan with early payment penalties. Before you accept such terms, assess the likelihood that you will pay off the loan early. Do you plan to sell your house or refinance it if interest rates go down? Do you anticipate winning a large settlement? If so, you must compare the costs of the penalties to the savings.

As an example, suppose that you take out a 30-year mortgage on $100,000 at a 5% annual rate, with a 2% prepayment penalty. Using a mortgage calculator and an amortization schedule, you compute that after 13 years, the remaining loan balance is $71,000, and the amount of interest left to be paid is $32,000.

Since (.02)(71000) = 1420, the pre-payment penalty for paying off the balance after 14 years is $1,420. That is far less than $32,000, so you come out ahead by paying off the balance.

Suppose that you have a 15-year home loan for $100,000 at an interest rate of 7%, and a pre-payment penalty equal to 6 months interest. At the end of 8 years, the amount of interest owed is $19,000, and the next 6 months of interest is $2,400.

In this case, the pre-payment penalty is steeper, but you will still come out ahead if you pay off the full balance.

Any time you consider making an early payment, use a mortgage calculator and amortization table to compute the amount of interest still owed, and the precise pre-payment penalty.

© Had2Know 2010