Avoiding Mortgage Prepay Penalties

Prepayment penalties can be a major concern to homeowners looking to refinance or pay off their homes. The most important thing to realize about a prepayment penalty is that it is a tool for the lending institutions to either maximize the amount of interest they are charging, or to maximize the time that a borrower stays in a specific loan structure. This tool ensures that the lender can make a profit on the loan. Prepayment penalties are basically charges added to your principle balance if you pay off your loan before a specific time period. It is important to realize the motivation for charging prepayment penalties if you want to avoid paying them.

There are two types of prepayment penalties. A soft prepayment penalty is only incurred if the borrower refinances their house. They are, however, able to sell their home without incurring any penalties. A hard prepayment penalty is incurred when the borrower refinances or sells their home. The average length of a prepayment penalty is anywhere from two to five years. There are also prepayment penalties that will charge you more if you pay over a certain percent of the principle off within a certain period of time. It is rare to have a prepayment penalty that lasts for longer than five years. Also, some prepayment penalties are reduced with the passage of time up until their expiration. That means that if you are already in a loan with a prepayment penalty, you may be able to reduce the amount you pay by waiting a little while. If you are looking to refinance into a lower interest rate, weigh the difference in the total savings of the new interest rate versus the total cost of the prepayment penalty. When doing this, also take into consideration how long you plan on staying in the house, and how long you anticipate to stay in your loan. If you are planning on moving soon, it might not be worth it to pay a large amount to reduce your payments for a short time period.

Prepayment penalties assure a larger amount of interest is payed to the lender because of loan amortization. The way a thirty year mortgage amortizes, the average borrower will be paying down their interest for eight to ten years before they start to aggressively reduce their principle balance. This means that the longer you are in a loan, the more interest the lending institution can accrue. Lenders often apply prepayment penalties to borrower's who may be prone to move or refinance early on in the life of the loan. This allows the lender to earn more interest on the loan.

The first type of borrower who frequently sees prepayment penalties are sub-prime borrowers. A sub-prime borrower is simply a borrower who does not conform to the requirements of a prime loan. Low credit scores are the most common reason that a borrower would be considered sub-prime. Sub-prime borrowers are more prone to refinance. This is because they are usually in higher interest loans then prime borrowers, making them more reactionary to interest rate fluctuations as they look for a lower rate. Sub-prime borrowers often have little choice in the structuring of their loan. It is often a " take it, or leave it " scenario where the borrower must accept higher interest rates and prepayment penalties to get the loan. It is sometimes possible to accept a slightly higher interest rate for a shorter prepayment penalty.

Adjustable rate mortgages often have prepayment penalties as well. This is to ensure that the borrower doesn't simply take the loan for the introductory rate, or "teaser " rate, and then refinance before the loan recasts into a higher interest rate. Also, adjustable rate mortgages are typically short term loans, where the borrower is either planning on refinancing, or selling their home in the near future. If you are planning on getting into an adjustable rate mortgage, remember that the shorter amount of time between rate adjustments in your loan the shorter your prepayment penalty will be. In other words, if your loan adjusts every six months, you will have a shorter prepayment penalty than if it adjusts after five years. If you are looking at an adjustable rate mortgage as a short term solution, consider how long you plan to be in the loan. It is often better to pay a little bit more in interest in a conventional loan than it is to pay a large percent of interest through a prepayment penalty.

Pay-Option ARMs or "pick-a-payment" loans often have a mandatory prepayment penalty. In a Pay-Option ARMs are adjustable rate mortgages where the borrower can decide which interest payment they would like to pay for each payment the make on their loan. Typically the borrower can choose to pay interest only, to pay based on the amortization of a thirty year loan ( sometimes also a fifteen year loan ), or they can pay the " minimum payment ". The minimum payment usually does not even cover the interest they owe on each payment and therefore the difference is considered differed interest, or interest added to your principle balance. In these loans the borrower will often have a low introductory rate that will adjust based on the remaining principle balance. Because of this adjustment, and the volatility of this loan, prepayment penalties are usually unavoidable. The Pay-Option ARM can be a useful loan, however the majority of borrowers will see little benefit from it, and if you are looking to avoid prepayment penalties, this loan should be avoided at all costs.

Prepayment penalties can be added to your loan for a slightly lower interest rate. This can be useful to a borrower who is not planning on moving or refinancing until after the prepayment penalty has expired. This is often a viable choice for prime borrowers, but usually does not apply to sub-prime. Most of the time, the borrower will be made aware that they have the option of lowering their interest rate by accepting prepayment penalties. Unfortunately, sometimes a broker will add the prepayment without telling the borrower as a way to offer them a more competitive interest rate. Be sure to ask if you are being charged a prepayment penalty every time you are discussing a loan.

A borrower who has recently had their property listed for sale through a realtor will usually be required to have a prepayment penalty. This is because the borrower has been actively trying to sell their property and the lender looks at this as an indication that the borrower will be paying the loan off early. One way to avoid this is to put your house up for sale by owner. Another way to avoid these costs is to wait for a year after you take your house off the market before trying to refinance. usually after a year (some lenders only require six months) the stipulation of a prepayment penalty no longer applies.

Mortgages involving Balloon Payments are also something to avoid if you wish to avoid prepayment penalties. Balloon payments leave the borrower with a large sum of unpaid debt at the end of the term of the loan. This is because it does not amortize fully. These loans usually involve a short term with an amortization schedule that is significantly longer. This means that if you are on a seven year balloon payment that amortizes like a thirty year loan, you are paying less interest if you refinance before the end of your term. Balloon loans are also looked at as short term loans and prepayment penalties usually apply.

Dishonest mortgage professionals can also cause a borrower to have a prepayment penalty. A mortgage professional can make more money by assessing a prepayment penalty, and some do without the borrower being aware of it.This is because the disclosure of a prepayment penalty is somewhat fuzzy. The disclosure documents that a borrower must sign ( and acknowledge they have read ) include a Truth in Lending document ( TIL ). The TIL will disclose your prepayment penalty as well as how long it lasts, and what you will be required to pay. Unfortunately, many borrowers do not read through the TIL fully. The document is often large and must be signed at least once on almost every page. On top of this, the language can sometimes be confusing or misleading. Be sure to read the TIL document carefully and thoroughly. Also get verbal confirmation regarding a prepayment penalty.

Short term loans often include a prepayment penalty as well. This is, again, because the lender wants to make the loan profitable for themselves by earning interest. Short term loans are usually meant to be a bridge between one situation and another. For instance, when a new home buyer purchases a house they will often have higher interest rates than a comparable borrower who can prove a history of timely mortgage payments. This means that first time home owners will usually get a shorter term loan and will then wait until they have made a few years of payments on it. At this point they are able to refinance at a lower rate. This is just one of a million reasons that a short term loan would be sought out. If you are entering into a short term loan, you should accept the fact that a prepayment penalty will probably be assessed. This is usually a fair trade off as long as you are not planning to move or refinance within the next two to three years.

Prepayment penalties are a fact of the modern mortgage industry. They can be avoided under certain circumstances, but are often the concession that a borrower must make to get the loan structure they desire. It is often possible to shorten or even eliminate your prepayment penalty by accepting a higher interest rate. This can be beneficial, depending on your situation. Remember that the longer you pay a higher interest rate, the less benefit you will see. In other words, if you are planning on refinancing in four years, you should consider accepting a prepayment penalty. This is because there is no benefit to paying a higher interest rate to eliminate it. If you are planning on moving or refinancing within the next one to two years, the extra amount of interest you pay will probably be less or equal to what you would pay in penalties.