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Prepayment Penalties: What They Are and How to Determine Whether the Cost Is Worth It

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You may have signed up for a 15- or 30-year loan with the intent to pay it down sooner. The sooner you pay off your mortgage, the less interest you'll be paying in the long run. What you didn't bet on, however, was the prepayment penalty in your mortgage contract. What a prepayment penalty is and how this can effect your early pay-off plans are discussed below.

What's a Prepayment Penalty?

Some mortgage contracts come with a prepayment penalty—yes, that's right, you can actually be charged extra for paying ahead. While this may seem like an odd thing for the mortgage company to do, it's important to understand where mortgage lenders make the majority of their money.

The mortgage lenders will take into consideration the mortgage you've chosen and add this to their profit—the more you pay in interest, the more the lending company will gain. When you pay your mortgage off early, however, the company will receive less in the way of profit. A prepayment penalty then is a way for the lending company to ensure they still make enough to cover their costs and get the money they had initially planned on.  

Can the Penalty Be Negotiated Down?

Depending on the prepayment penalty terms laid out in your mortgage contract, you may be able to negotiate the penalty down.

The majority of prepayment penalties don't last for the entirety of the mortgage term. If you have a 15-year mortgage, for example, you might only be penalized for prepayment through year 5 of your loan term. In a case such as this, you may be able to ask them to lower the 5-year penalty term to 3 or even 2 years. You likely won't be able to get rid of the penalty altogether, but that small decrease may be the difference you need to make paying the penalty worth it.  

Is the Penalty Worth It?

Each prepayment penalty will have different costs associated with it, and while some prepayment penalties can be hefty, they may be worth it in the end.

To fully understand the costs of your prepayment penalty and how they'd stack up against saved interest payments, you may want to sit down with a loan counselor or financial consultant. A common penalty ranges from 2% to 4% of the initial mortgage balance. This means that a 4% penalty on your $150,000 mortgage would only be $6,000. If you could save even $1,000 more than that in the long run, paying the penalty to get a lower interest rate or shorter mortgage term may be worth it.

While prepayment penalties may initially seem confusing, they're a simple safehold put in place by some lending companies to ensure that projected profits and actual profits aren't too far off. To learn more about prepayment penalties and how you may benefit from paying it in order to pay off your mortgage sooner, talk with your mortgage lender or financial consultant about your mortgage rates.