What is a Prepayment Penalty?

A prepayment penalty is a clause in some mortgage contracts that states the home buyer must pay a fee for paying off the mortgage within a specified number of months.

A Longer Definition: Prepayment Penalty

Understanding Prepayment Penalty

A prepayment penalty is a mortgage contract clause stating that the home buyer will be assessed a fee for paying off the mortgage loan within a specified time frame. Lenders use prepayment penalties to discourage home buyers from refinancing their mortgages or selling their homes too quickly after settlement.

The prepayment penalty fee is typically a percentage of the home buyer’s remaining loan balance, up to 5 percent. However, first-time home buyers should not expect to see a prepayment penalty included in their mortgage.

Since 2009, prepayment penalties have been rare. Today, they only exist with portfolio mortgages and other mortgages issued by local banks and credit unions such as home equity loans. None of the popular mortgage loan types backed by the government—conventional, FHA, USDA, and VA—include the prepayment penalty clause.

Prepayment penalty statistics

According to the FFEIC and data from the Home Mortgage Disclosure Act (HMDA), no mortgages were made to home buyers between 2018-2022 linked to conventional mortgages, FHA mortgages, USDA mortgages, or VA mortgages that also had prepayment penalties.

All prepayment penalties were linked to home equity loans, portfolio loans, and other non-standard mortgage types.

Prepayment Penalty: A Real World Example

Imagine a first-time homebuyer purchasing a non-warrantable condo in a newly-built building. Because the condo is non-warrantable, it’s ineligible for traditional mortgage financing. So, the home buyer uses a local bank to finance the property and accepts its non-warrantable condo mortgage terms including higher fees and an above-market interest rate to compensate for risk, and a 2-year percent prepayment penalty equal to 1% of the balance.

After a year of living in the condo, the buyer’s condo building status changes to warrantable condo status, which means that the buyer can potentially refinance to a standard mortgage at today’s lower rates. However, because it’s still within 24 months of closing, refinancing would trigger the 1% prepayment penalty clause in the buyer’s original mortgage.

The buyer decides that the refinancing benefits outweigh the prepayment penalty cost, which is added to their loan balance as part of the transaction.

Common Questions About Prepayment Penalty

What triggers a mortgage prepayment penalty?

A mortgage prepayment penalty is typically triggered when a home buyer pays off a large portion or all of their mortgage loan before the agreed-upon time frame in their mortgage contract expires. Triggering a prepayment penalty usually occurs through refinancing, but can also happen from selling your home or making large lump-sum payments.

Are prepayment penalties legal?

Yes, prepayment penalties are legal, but the allowable terms vary by state and lender. Some states have specific regulations regarding the maximum penalty allowed or the duration during which a penalty can be applied.

How can I avoid a prepayment penalty?

The best way to avoid a prepayment penalty is to choose a mortgage that doesn’t include one. The good news is that prepayment penalties are exceedingly rare. In 2022, exactly 0 home buyers using a conventional, FHA, USDA, or VA loan were given a prepayment penalty.

See more mortgage statistics here.

Can I negotiate the prepayment penalty terms?

In some cases, home buyers can negotiate the terms of their prepayment penalty—but only before signing a mortgage agreement. Negotiations may involve reducing the penalty amount or shortening the penalty period.

How is a prepayment penalty calculated?

The calculation method for a prepayment penalty varies. The most common type of calculation is as a percentage of the remaining loan balance, but flat fees or a certain number of months’ interest are common, too.