What is a prepayment penalty on a mortgage? A fee for paying a loan off early, now rare on home loans because Regulation Z allows one only on a fixed-rate qualified mortgage, for at most three years, with caps.
A prepayment penalty is a fee for paying off a loan, or a large part of it, ahead of schedule. It exists so a lender that priced a loan on years of interest is compensated when the interest stops early, and it is triggered by a refinance or a sale as readily as by a windfall. On owner-occupied home loans in the United States it is now uncommon, because the rules that followed the 2008 crisis made it hard to include one.
Regulation Z is the reason. Under 12 CFR 1026.43(g) a covered transaction may carry a prepayment penalty only if it is a qualified mortgage, is not a higher-priced mortgage loan, and has a rate that cannot rise after consummation, which in practice means a fixed rate. The penalty may not run past the first 36 months, and it is capped at 2 percent of the amount prepaid during the first two years and 1 percent during the third. A lender offering a loan with a penalty must also offer a comparable one without. FHA, VA and USDA loans do not permit them at all.
Where they still turn up is outside that world. Investment-property and business-purpose loans from non-agency lenders sit beyond the consumer rules and often carry one, and a home equity line of credit commonly carries an early-closure fee that recovers the closing costs the lender waived if the line is shut within the first two or three years. Both are disclosed in writing. On a purchase or refinance the loan estimate answers it with a yes or no on page one and the note states the terms; on a home equity line it is in the credit agreement. A $300,000 loan paid off in year two under a 2 percent penalty, with about $293,000 then outstanding, costs roughly $5,900.
A worked example
A $300,000 fixed-rate loan carries a 2 percent prepayment penalty for its first two years. The borrower sells in month 20 with about $293,000 outstanding, and the payoff statement adds roughly $5,900. The same loan paid off in month 40 carries nothing, because Regulation Z caps the penalty period at 36 months and the third year at 1 percent.
The page the penalty is disclosed on
Questions people ask
Do most mortgages have a prepayment penalty?
No. On owner-occupied home loans they are now uncommon, and FHA, VA and USDA loans prohibit them outright. Regulation Z permits one only on a fixed-rate qualified mortgage that is not higher-priced, for at most 36 months, and the lender must also offer a loan without one.
Where do you find out if a loan has a prepayment penalty?
The loan estimate answers it with a yes or no on page one and the closing disclosure repeats it, while the note states the terms. On a home equity line the equivalent is the early-closure fee, and it is in the credit agreement.