A charge the lender makes when a mortgage is repaid before a certain period of time elapses. In effect, you are "penalized" for paying off your mortgage early. Not all lenders impose a prepayment penalty.
From a mortgage lender’s perspective a prepayment penalty helps the lender at least recoup some or all of the significant expense it incurs in putting a new loan on the books. If the loan is to be repaid quickly, such as if you refinance it elsewhere, the lender can incur a loss, as it has not had time to make up the costs it advanced. Lenders also know a mortgage prepayment penalty discourages prepayment.
As a practical matter prepayment penalties decline or disappear over the passage of the loan’s life. Rarely do prepayment penalties apply after the fifth year of a loan’s existence as a general rule. Partial pre-payments up to twenty percent (20%) of the existing loan’s balance are usually allowed in any one year by the borrower without any penalty.
Rarely are prepayment penalties waived by the lender after the loan documentation is signed by the lender and the borrower and the loan is received.
A prepayment penalty must be clearly set forth in all loan paperwork to the borrower, as required by federal truth in lending requirements.
When a loan has a prepayment penalty tied to it expressly in writing, the benefit to the consumer is that the interest rate that the consumer pays with the loan is typically reduced by 1/8% compared with a loan that does not have a prepayment penalty.
Consumers need to carefully read all loan documentation before signing. Many times there are express prepayment penalties in the paperwork. A borrower needs to understand that he or she can negotiate with the lender as to any prepayment penalty provision as to its length of time, its amount, or even if the loan will have a prepayment penalty provision. The borrower needs to understand that the lender wants the loan to go through with the borrower and if the consumer indicates he or she will go elsewhere for a loan the lender may waive the prepayment penalty provision concerning the loan.
It is very important that a borrower discuss with his mortgage broker and the escrow officer all questions about the loan documentation before the loan closes. Under federal law, a borrower has three days after loan documents are signed at escrow to cancel the loan without penalty.