Prepayment Penalty

If a borrower takes out a mortgage and then decides to repay it in full just a few years later they may be liable to pay a prepayment penalty. People often wonder why they should have to pay this penalty. After all, surely the lender should be happy they’re getting their money back, right? Well, not really. Let me explain. But first, let’s go through the basics of the prepayment penalty.

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Example: You take a mortgage with a term of 30 years. Two years later, you decide to refinance or sell your house. Now, there may be a provision in your mortgage contract that states that if you pay the balance of the mortgage you must pay a penalty to the lender of up to 4 percent of your total loan amount.

Now, that may seem like a cruel penalty. However, when you think about it, it makes perfect sense. After all, the lender is risking money by offering you a mortgage on the expectation that you will repay much more than the initial principal. If you repay the loan early the lender will not only lose the potential interest but may also fail to recoup the cost of arranging your mortgage in the first place.

Before arranging a mortgage you should think about what your intentions are. If you may choose to sell your property within 5 years of taking your mortgage you should ensure that there will be no repayment penalty. If you are fairly certain you will stay in the property more than 5 years you may want to accept a prepayment penalty clause as it should bring down your interest rate.