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Paying a mortgage off early seems like a good idea, but only if you don't have a penalty. Because lenders lose potential revenue when you pay off early, mortgages sometimes carry prepayment penalties. This means you will pay a percentage of your balance for paying the loan earlier. Seeing as this can be several thousand dollars, it can often be a deterrent to early payoff.
Reasons for a Prepayment Penalty
A prepayment penalty is protection for the lender. In addition to any upfront fees, the lender makes a profit on the interest you pay over the life of a loan. On a $250,000 loan with a 5 percent interest rate over 30 years, the lender will make $229,910. Refinance that loan with another lender after a year, and the first lender will only make a fraction of that. By charging a prepayment penalty, the lender may discourage you from going elsewhere. If it doesn't deter you, the bank will get one last fee as a parting shot before you go.
How the Penalty Works
A prepayment penalty is a percentage of your unpaid balance. It may be a fixed percent. For example, it might be 2 percent if you pay in the first five years. It can also be on a scale -- for example, you might pay 5 percent in year one, 4 percent in year two, 3 percent in year three and so on. So if your prepayment penalty is 2 percent on a balance of $200,000, you will have to pay a $4,000 penalty to pay off early.
If you have a prepayment penalty, it will be outlined in the promissory note. This is the primary document you sign at closing outlining the terms and conditions of the loan. There will be a separate clause detailing the penalty. Read the note carefully at closing to make sure the prepayment penalty is what you expected. This is why it is a good idea to review your documents prior to closing. If anything is contrary to your expectations, contact your lender to attempt to resolve the matter.
Getting Out of the Penalty
Lenders are usually stubborn when it comes to a prepayment penalty. After all, it exists for their benefit. However, you can negotiate to have it reduced or even cancelled outright. If a lender is going to agree to waive a prepayment penalty, you will have to show strong mitigating factors. Banks will almost always waive the prepayment penalty if you refinance there as opposed to going through another lender. By getting the new loan, the bank isn't losing nearly as much as if you went elsewhere. Another compensating factor is large deposits with the bank. While it may hurt to lose your loan, it will hurt even more to lose your deposits along with it. As long as the bank doesn't suffer a great loss, or it stands to gain in the long run by accommodating you, you have a chance to eliminate the penalty.