What is a mortgage prepayment penalty?

Mortgage lenders make money primarily through interest payments, which means many loans come with a mortgage prepayment penalty. And while not impossible to prepay your mortgage, it’s important to understand prepayment penalties and how they work. 

How penalties vary by lender

Some lenders charge prepayment penalties for paying out the loan balance in one payment. Penalties will differ depending upon the loan’s length and the corresponding interest charges. Some utilize the remainder of your outstanding loan balance, while others can use sliding payments based on time you’ve spent repaying your mortgage. 

Should you accept a loan with a prepayment fee?

Prepayment penalties are meant to keep borrowers from paying off their loans before the end of the loan term. In some cases, they can reduce the benefits of eliminating the debt and avoiding interest. Prepayment can also cause temporary damage to your credit score. 

However, not every loan includes a prepayment penalty clause. Regardless of whether you anticipate refinancing or paying your mortgage early, it’s important to understand the terms and conditions from your lender.

How much do prepayment penalties cost?

There are a few ways lenders calculate a prepayment penalty. Often, it can be a small percentage of your remaining balance. This means you’ll pay a higher penalty the sooner you pay off the loan.

As mentioned earlier, some lenders will charge a certain number of months’ worth of interest, while others use a sliding scale based on the length of the mortgage. It’s also possible for a prepayment penalty to be a fixed amount, though this is more common in personal loans compared to mortgages.

Prepayment penalty examples

How does the math actually work for prepayment penalties? For a percentage of the remaining balance, consider a mortgage loan of $200,000. If the penalty is equal to 2%, and you’ve only paid $20,000 of the loan amount (10%), your penalty would come to $3600:

200,000 - 20,000 = 180,000 

180,000 x 2% = 3,600

There are definite advantages to paying off a mortgage early. However, it’s crucial to understand the terms of your loan and whether a prepayment penalty fee is something you need to consider.