Monday, October 13, 2008

Prepayment Penalties

If a loan has a prepayment penalty, that means the borrowers will have to pay a penalty if they pay off more than a certain percentage of the loan principal before the prepayment penalty period expires. Generally, even with a prepayment penalty, borrowers can pay off 20% of the loan amount each year and not be penalized. The penalty period can be up to three years, and is typically either 6 months interest, or 1% of the loan amount for every year remaining in the penalty period (3% the first year, 2% the second year, 1% the third year). Prepayment penalties do not have to be three years long, however. They could be for one year or two years, also.

There are two different types of prepayment penalties. One is called a "hard" prepay and the other is a "soft" prepay. A hard prepayment penalty penalizes the borrower if the borrower sells the house or refinances the house. A soft prepayment penalty penalizes the borrower if the house is refinanced, but not if the house is sold. Some prepayment penalties are hard for the first year and soft for the remaining years. In that case, the borrower could sell the house after owning it for one year and avoid the penalty, but they would incur the penalty if they refinanced it before the penalty period was over.

Why do some loans have prepayment penalties and others do not? It's simple -- the mortgage broker gets paid a rebate from the lender if there's a penalty, and the rebate gets larger as the penalty period gets longer. Lenders encourage mortgage brokers to sell loans with prepayment penalties because the lender is able to trap the borrower in the loan.

There is no reason to ever have a prepayment penalty on a loan. It only benefits the mortgage broker and the lender. A borrower is certainly not helped by a prepayment penalty, and a real estate agent will get fewer referrals from buyers who have been directed towards mortgage brokers who sell loans with prepayment penalties.

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