- A prepayment penalty is a fee for paying off your mortgage early.
- You’ll probably only pay a penalty if you pay off the mortgage, refinance, or sell within a few years of taking out your original mortgage.
- Conventional mortgages can come with prepayment penalties, but you won’t pay on USDA, VA, or single-family FHA mortgages.
- If a lender offers you a mortgage with a prepayment penalty, it has to present an alternative mortgage with no penalty.
- SmartAsset’s free tool can find a financial planner to help you take control of your money »
What is a mortgage prepayment penalty, and how does it work?
A mortgage prepayment penalty is a fee you pay the lender if you sell, refinance, or pay off your mortgage within a certain amount of time of closing on your initial mortgage — usually three to five years.
You probably won’t have to pay a penalty if you pay extra toward your mortgage every month, or if you make supplemental payments here and there. It will likely only be if you either a) pay off the mortgage completely by making a large payment, selling, or refinancing, or b) pay off a huge portion of your mortgage all at once.
Even if your lender charges a prepayment penalty, you still might save more money by paying off your mortgage early.
The terms of your prepayment penalty will be included in the documents you sign at closing, but your lender should inform you about penalties well before then. If a lender provides a mortgage that includes prepayment penalties, it is also legally required to offer you an alternative mortgage that doesn’t charge penalties. If you’re already in the homebuying process and your lender hasn’t brought up the subject yet, don’t be afraid to ask.
Some mortgages impose hard penalties and others have soft penalties.
With a hard penalty, you’ll pay a fee if you sell or refinance your home. But with a soft penalty, you’ll only pay if you refinance — you can sell at no extra cost. Again, the details about whether you have a hard or soft penalty should be spelled out in your closing documents.
Legally, lenders can’t charge prepayment penalties on certain types of mortgages. You won’t pay a penalty on most government-backed mortgages, including VA, USDA, and single-family FHA mortgages.
You might have a prepayment penalty on a conventional mortgage, but remember that your lender is legally required to offer you an alternative without a prepayment penalty.
Each lender has its own methods for charging mortgage prepayment penalties. Here are some possibilities:
- Fixed fee: Maybe you’d pay $500, regardless of when you pay off the mortgage or how much of the mortgage is left when you refinance.
- A percentage of the remaining mortgage when you sell or refinance: Let’s say you still owe $100,000 when you refinance your home, and the prepayment penalty is 4%. You’d pay 4% of $100,000, or $4,000.
- Interest: For example, you might have to pay six months worth of interest.
Talk to your lender or refer to your closing documents to learn all the details of your prepayment penalty.
If you pay off your mortgage super early, like within a few years of taking out your loan, the lender misses out on up to tens of thousands of dollars you would have paid in interest over the years.
If you refinance, you could go through a different lender. If you sell, there’s a good chance the buyer will use a different lender. Regardless, your current lender would miss out on money.
A prepayment penalty may discourage you from paying off your mortgage early, so the lender gets to keep your business. If you do pay off the loan early, the lender at least offsets that loss by a little bit.
Depending on your situation, you may decide that incurring a prepayment penalty is worth it. For example, if you pay a $500 flat fee for paying off your mortgage early but save $10,000 in interest, you may still choose to go for it.
Laura Grace Tarpley is the associate editor of banking and mortgages at Personal Finance Insider, covering mortgages, refinancing, bank accounts, and bank reviews.
Disclosure: This post is brought to you by the Personal Finance Insider team. We occasionally highlight financial products and services that can help you make smarter decisions with your money. We do not give investment advice or encourage you to adopt a certain investment strategy. What you decide to do with your money is up to you. If you take action based on one of our recommendations, we get a small share of the revenue from our commerce partners. This does not influence whether we feature a financial product or service. We operate independently from our advertising sales team.