What Is a Mortgage Prepayment Penalty?

If you have extra money to put toward your mortgage, you may be tempted to pay off your home loan early. Doing so could save you a lot of money on interest. Similarly, it's common to refinance a mortgage when rates come down. But if your initial loan has an early mortgage payment penalty, both of those decisions could come at a cost. Here, we'll review what a mortgage prepayment penalty entails and how much it might cost you if your loan has one.

What is a mortgage prepayment penalty?

A prepayment penalty is a fee lenders charge when you pay off your loan early. Mortgage lenders make money from the interest they charge on a home loan over time. So the sooner you pay off your mortgage, the less interest your lender will get to collect.

To compensate for this loss, your lender might impose a mortgage prepayment penalty.

For example, say you take out a $200,000, 30-year fixed-rate mortgage at 3% interest. In this scenario, we'll imagine you stick to the repayment schedule. Your lender collects $103,554.53 in interest over those three decades. But if you manage to repay that loan in 27 years instead of 30, your lender will collect about $11,500 less in interest. From the lender's perspective, that's not ideal. This is why your mortgage might come with a prepayment penalty clause.

Wondering whether your mortgage has a prepayment penalty? If your mortgage does contain a prepayment penalty, your lender must make that clear. Specifically, your lender is required to include that information on your monthly mortgage statements or in statements containing notices of interest rate adjustments (which apply if you don't have a fixed mortgage, but rather, a variable interest rate on your loan).

How much does a prepayment penalty cost?

A mortgage prepayment penalty can equal 2% of a loan balance within the first two years, and 1% in its third year. So for a $200,000 non-conforming loan, your prepayment penalty could cost up to $4,000.

Thankfully, most homeowners don't need to worry about prepayment penalties. The Dodd-Frank Act eliminated the prepayment penalty for all conforming mortgages signed on Jan. 10, 2014 or later. Conforming mortgages are those that adhere to the financing limits established by the Federal Housing Finance Agency and that meet the underwriting guidelines set by Fannie Mae and Freddie Mac.

But loans signed prior to Jan. 10, 2014 may include a prepayment payment. And non-conforming loans signed after that date may have a prepayment penalty that applies within the first three years of a loan's repayment period.

Can a prepayment penalty be avoided?

Yes -- but only before you sign your mortgage. If you have an existing mortgage with a prepayment penalty, there's nothing you can do.

These days, the majority of mortgages do not have prepayment penalties. Conforming loans, as well as FHA, VA, and USDA loans, cannot include that penalty. So if you borrow via one of these channels, you should be able to completely avoid the prepayment penalty.

On the other hand, if you take out a jumbo mortgage (you borrow more than the limits set forth by Fannie Mae and Freddie Mac), your home loan may be subject to a prepayment penalty. This means that if you sell your home soon after closing, or you try refinancing your mortgage, you might get stuck with a prepayment penalty.

Is it worth it to pay a mortgage off early?

Sometimes. In some cases, refinancing will save you thousands -- more than enough to cover the cost of a mortgage prepayment penalty. For example, imagine you're looking at a $4,000 penalty to pay off your mortgage early via a refinance. If the refinance lowers your monthly payment by $200 over multiple decades, it's worth it.

Perhaps mortgage rates have fallen significantly since you signed your initial loan, or that your credit score has improved enough to render you eligible for a much lower interest rate. In that case, refinancing could save you a lot of money over time. Use our mortgage interest calculator to see how much a lower interest rate could save you each month.

The bottom line on mortgage prepayment penalties

Thankfully, mortgage prepayment penalties are fairly rare these days. You can avoid one by taking out a conforming loan, or an FHA, VA, or USDA loan (if you qualify).

If you're getting a non-conforming mortgage, your loan may be subject to an early mortgage payment penalty. Read your loan documentation carefully. Your lender is required to provide you with a detailed summary of your loan terms. As a result, your mortgage should state explicitly whether it comes with a prepayment penalty or not.

Shop around with different lenders, since you may find that not all of them charge a pre-payment penalty. And if you're a strong loan candidate -- meaning, you have a good credit score, little debt, and a healthy income -- you may be able to negotiate a prepayment penalty out of your loan contract.

Still have questions?

Here are some other questions we've answered:

• What Are Mortgage Points and How Do They Work?
• No Appraisal Refinances: Do You Qualify and Is One Right for You?
• What Is a Fixed Rate Mortgage?