Why Pay Mortgage Prepayment Penalties?

First and foremost what are mortgage prepayment penalties? How do they affect your home buying decisions? How do some lenders justify imposing prepayment penalties? Could prepayment penalties ever be thought of as prepayment privileges? These are some of the questions that will be discussed in this article and during the discussion we will attempt to provide some reasonable answers.

Prepayment penalties have been around for as long as interest rates were. A prepayment penalty in its purest form is a fee imposed by the mortgage lender when a home owner repays a mortgage in full prior to the due date. The time frame has been modified with the advent of long term (20, 25 & 30 years duration) fixed rate mortgages and as a result most prepayment penalties are imposed on ARMs (Adjustable Rate Mortgages) due to the shorter terms an interest rate and the payment associated with it remains fixed (sometimes as little as 1 year and could be as short as 30 days depending on where in the world you are).

Prepayment penalties should not affect your buying options if you are able to identify types of mortgages that are likely to impose such penalties. For example, when you take a close look at available mortgage types and realize that a fixed rate mortgage carries the same interest rate and payment of principal & interest (as stated above) for the duration of the mortgage loan term; and ARMs provide for changes in the interest rate and principal & interest payment, you may draw your own conclusion as to which of these mortgage types carry a prepayment penalty, and the reason behind such penalty.

Let’s take a closer look. A home buyer who closes on his/her transaction in a high interest rate market looks forward to the day when fall two to three percentage points below the interest rate s/he reluctantly closed at so a refi (refinance) into a lower interest rate may be possible. When such a refi occurs it is great for the homeowner, but not so great for the lender/servicer/mortgage holder who stands to lose money, so to prevent this from happening a prepayment penalty clause inserted in the mortgage documents helps to prevent such a refi from taking place in order to protect the lender’s interest.

The reasoning put forth by many mortgage lenders to justify imposing prepayment penalties is the need to have a minimum guarantee of interest on the funds they lend to home buyers. In other words, if you borrowed $100,000 at an annual rate of 10 percent for a term of 30 years, you would agree in the mortgage documents to repay the principal amount of $100,000 plus interest in the amount of $300,000 (using a simple calculation) in interest payments over the thirty year period. The clause that provides a way out of a fixed rate mortgage and allows you to prepay without a penalty is, “if you keep the mortgage loan for the full 30 years”.

If instead you borrowed the same amount ($100,000) but the rate adjusted each year (a one year ARM), your rate would not start at 10 percent but perhaps 3 percentage points lower – or 7 percent – your lender would most likely insist on a prepayment penalty. Why? The first reason is that you borrowed 7 percent funds in a 10 percent market and therefore your lender will sustain a loss each year unless steps are taken that would lessen the 3 point loss. One of these steps could be to increase the points charged at closing, but that could present a problem due to your increased cash outlay. The other step would be the imposition of a prepayment penalty for the first three years.

Chances are that prepayment penalties would be imposed only on certain types of ARMs,
so it will be necessary to examine your mortgage docs (Truth-in-Lending disclosure) or consult with your loan specialist who would tell you if there is a mortgage prepayment penalty on your mortgage as well as do a mortgage prepayment calculation for you if there is one. In just about every mention of the charge one has to pay as a consequence of prepaying his/her mortgage, the term used to describe such a charge was prepayment penalty until a few lenders introduced a different term, “prepayment privilege” to identify the early prepayment of a mortgage.

Lenders who proposed the new term reasoned that, since prepayment of a mortgage would be beneficial to the homeowner (after all, why would a homeowner want to prepay his/her home mortgage unless s/he got a great deal on a sale or a new “lower” interest rate) and therefore that homeowner would be paying for the privilege of getting out of an otherwise binding contract earlier than agreed upon; Thus the term prepayment privilege. Needless to say that term did not stick (around too long) because, ultimately, having to pay any kind of a fee or charge always feel more like a penalty than a privilege.

A message to Prime Mortgages readers:

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