What Is A Prepayment Penalty?

First, let’s explain what a prepayment is with respect to a home loan. A prepayment is any amount paid by the borrower that exceeds the scheduled monthly principal and interest payment as required by the terms of the loan. A very basic example of prepayment is illustrated below:

All loans allow borrowers to make prepayments of any amount at any time during the term of the loan. Prepayments usually occur in three situations.

• When an amount paid monthly exceeds the regular payment.
  
• When an existing loan is paid off as part of a refinance.
  
• When an existing loan is paid off as part of a sale.

Most loans allow borrowers to make these prepayments without incurring any additional costs. Thus, leaving the balance of loans which allow borrowers to make prepayments albeit subjecting themselves to possible prepayment penalties.

While they can vary, most loans with prepayment penalties generally share the following characteristics:

1. Prepayment Penalty Periods typically range from one to five years with the most common term being three years. Once this period has expired you will not be assessed a penalty if you prepay the loan.
   
   
2. Most lenders allow the borrower to prepay up to 20% of the original loan balance within any consecutive twelve month period (not calendar year) without incurring a penalty.
   
   
3. The actual dollar amount of the penalty is usually calculated in one of three ways:
   

   a. Assessed only during the Prepayment Penalty Period as a fixed percentage, usually three percent, of the prepaid amount that exceeds 20% of the original loan balance.
   
   
   
   b. Assessed only during the Prepayment Penalty Period as a declining percentage, usually 3% first year, 2% second year and 1% thereafter, of the prepaid amount that exceeds 20 % of the original loan balance.
   
   
   
   c. Assessed only during the Prepayment Penalty Period as six months of interest collected on the prepaid amount that exceeds 20% of the original loan balance.
   
   

Next, let’s see how a prepayment penalty is calculated. Once again we will assume the loan terms used in the earlier example:

And further assume that the borrower has made 18 monthly payments of $1,945.79 and now wants to pay off the remaining balance.

Step 1

Determine the amount on which the penalty will be assessed

Step 2

Calculate the penalty amount using the percentages in 3a, 3b and 3c above

3a Calculations: (Assessed only during the Prepayment Penalty Period as a fixed percentage usually 3% of the prepaid amount that exceeds 20% of the original loan balance.)
	Assessed Balance		$235,121.60
	Penalty Percentage		3%
	Prepayment Penalty		8,853.65
3b Calculations: (Assessed only during the Prepayment Penalty Period as a fixed percentage usually 3% of the prepaid amount that exceeds 20% of the original loan balance.)
	Assessed Balance		$235,121.60
	Penalty Percentage (2nd year)		2%
	Prepayment Penalty		4,702.43
3c Calculations: (Assessed only during the Prepayment Penalty Period as a fixed percentage usually 3% of the prepaid amount that exceeds 20% of the original loan balance.)
	Assessed Balance		$235,121.60
	Penalty		(6 months interest)
	Annual Interest Rate	6.750%
	12 Months Interest	15,870.70
	Prepayment Penalty (6 mos. int.)	($15,870.70 / 2)	7,935.35

Another characteristic of a loan with a prepayment penalty feature is whether the prepayment penalty is “hard” or “soft”. Essentially, a “hard” prepayment penalty will be assessed anytime a prepayment is made which is greater than 20% of the original loan balance including refinances and sales. Whereas a loan with a “soft” prepayment penalty allows the borrower to payoff the loan without penalty in the event of the sale of the property. Given a choice, the borrower would be much wiser to choose a “soft’ rather than a “hard” prepayment penalty. However, at Preferred Financial we believe the best choice is probably to select a loan without any type of prepayment penalty.

In most cases a borrower will have a choice in the matter. While it may not be represented that way, a borrower should ask the lender or mortgage broker if there is a loan available without a prepayment penalty. Let’s take a look at a lender’s Wholesale Rate Sheet for an adjustable rate loan tied to the 11th District Cost of Funds Index. Below, you can see what a mortgage broker sees before you are quoted a loan program and rate.

11 th District Cost of Funds

1. Loan Amount – This assumes any loan amount from a low of $25,000 to a high of $600,000. For our example, we will assume a loan amount of $400,000 which is clearly within the required range
   
   
2. Margin – This is the fixed amount that is added to the index (in this case the index is the 11th District Cost of Funds) to determine exactly what your adjustable rate is on a monthly basis. Here you will notice that the margins range from a low of 3.00% to a high of 3.50%. The difference is .50% so a borrower who receives a margin of 3.50% will pay an interest rate .50% higher than a borrower who receives a margin of 3.00%. In our $400,000 loan example, this means the loan with the higher margin would require the borrower pay an additional $2,000 per year in interest.
   
   
3. Rebate – This represents the percentage of the loan amount a lender would pay to the mortgage broker at time of loan closing. The rebates range from 0% to 2% depending upon the margin percentage….the higher the margin the higher the rate, the higher the rate the more the lender likes the loan, the more the lender likes the loan the more rebate the lender will pay to the broker. A mortgage broker originating a $400,000 loan with a margin of 3.50% would receive a rebate of $8,000 from the lender at time of closing. This $8,000 rebate is quite different from the rebate the lender would pay the mortgage broker who originated a loan with a 3.00% margin…..here, the rebate would be zero!
   
   
4. Pre-Pay – This section of the wholesale rate sheet simply indicates which loan selection will carry a prepayment penalty and which will not. You need not be a rocket scientist to understand that a lender likes the higher interest rates and as such would also like to keep these loans on their books for as long as possible. Hence, prepayment penalties are assigned to the higher interest rate loans.

So then, if you are being offered a loan with a prepayment penalty, you absolutely need to ask if there is a loan you qualify for that does not have a prepayment requirement. Actually, here are a few other questions you should ask:

1. What lender is offering this loan?
   
   
2. Can you provide me with a copy of their rate sheet?
   
   
3. How much will you be paid if I accept the loan you are proposing?
   
   
4. Will I be charged any points for the proposed loan?
   
   
5. Will you be paying any of my closing costs with the rebate, if any, you will be receiving?
   
   
6. Why did you suggest the loan with the prepayment penalty?
   

There is absolutely nothing wrong with asking any of these questions. In fact, if you ask the questions and do not receive an adequate answer it may be time to look for a new mortgage broker.

Here is another lender Wholesale Rate Sheet that looks a bit different from the one used in the example above.

Without Prepayment Penalty

With Three Year Prepayment Penalty

What can you conclude from the above examples? Hint, compare the rebates paid to the broker for a no prepayment loan with a margin of 2.800% (1.563%) versus a prepayment loan with a margin of 2.800% (2.375%)…….if a borrower were considering a $400,000 loan the respective rebates paid to the broker would be $6,252.00 for no prepayment loan and a whopping $9,500.00 with a prepayment loan. We would be pleased to hear your thoughts and answer any questions you might have with respect to prepayment penalties or any other matter related to real estate financing.

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