Prepayment Penalty

Borrowers are often required to pay an amount of charge to the lender on account of repaying their mortgage loans before the termination of the loan period. Such a kind of payment is known as prepayment penalty. Lenders usually charge such penalties in order to make up for the loss in interest payments due to prepayment of the loan.

For example, Jenny took a mortgage of $500,000 for 6 years from Ronald. He repaid the full mortgage amount at the end of 5 years. In return, Ronald charged him a sum of $1000 for prepaying the mortgage amount. This amount is known as Prepayment Penalty.

Features:

• Lenders impose prepayment penalties in order to prevent borrowers from refinancing their mortgages when the market rates are sufficiently low. They may also demand a penalty when the borrower pays an amount equal to 20% of the original principal balance. Lenders often accept low rates on a mortgage in return of the prepayment penalty.
  
  
• State laws regulate the amount of prepayment penalty and the types of penalty that are charged by a lender. Prepayment penalty is expressed as a percentage of the outstanding loan balance at the time of prepayment or it can be equal to the interest for a number of months from the date of prepayment.
  
  
• The provision for prepayment penalty should be stated in the Truth-in-Lending disclosure. Prepayment penalties are imposed on adjustable rate mortgages and sometimes on fixed rate mortgages.
  
  
• Prepayment penalty is charged not only when a borrower refinances his existing loan but also if he pays off the mortgage by selling his property.
  
  
• Generally, prepayment penalty is deductible only when it is paid at the time of closing of the new loan. But it should be equal to the amount paid at closing.
  

A prepayment penalty helps the lender in the sense that he can compensate for the loss in the interest he could have received had the borrower not repaid the loan. On the other hand, borrowers can repay their mortgages before the scheduled time and pay prepayment penalty, thereby saving several dollars in total interest due to the reduction in time period.