Question

e) What types of borrowers would generally not want to buy points on a fixed-rate mortgage? And are prepayment penalties common for this type of loan? Explain.

Answer 1

Prepayment Penalty

А prepayment penalty is a fee that is charged If you pay off your mortgage too quickly Either by refinancing, selling, or prepaying

There Are Two Types of Prepayment Penalties

• There are soft prepays and hard prepays
• A soft prepay allows for the sale of the home without penalty
• But penalizes you if you refinance the mortgage
• A hard prepay penalizes you for a home sale or a refinance

A prepayment penalty, also known as a “prepay” in the industry, is an agreement between a borrower and a bank or mortgage lender that regulates what the borrower is allowed to pay off and when. Most mortgage lenders allow borrowers to pay off up to 20 percent of the loan balance each year.

A soft prepayment penalty allows a borrower to sell their home at anytime without penalty, but if they choose to refinance the mortgage, they will be subject to the prepayment penalty.

A hard prepayment penalty, on the other hand, sticks the borrower with a penalty if they sell their home OR refinance their mortgage. Obviously, this is the tougher of the two, and basically gives a borrower no option of jumping ship if they need to sell their home quickly after obtaining a mortgage.

Most prepays only last 1-3 years, but in the event that you need to refinance or sell your home unexpectedly, the prepayment penalty can be quite severe.

prepayment penalty cost

• It can vary by lender
• But it might be 80% of six months interest
• Meaning six months of interest-only mortgage payments
• Multiplied by 80%, which can be very expensive depending on the loan amount and interest rate

The prepayment penalty fee is often 80% of six months interest. It can vary, but in our example it is 80% because the lender allows the borrower to pay off 20% of the loan balance each year, so the penalty only hits the borrower for 80%.

The six months interest is the interest-only portion of the mortgage payment the borrower secured when they took out the mortgage.

So if a borrower has a mortgage rate of 6.5% on a $500,000 loan amount, their interest-only payment comes out to $2708.33 per month. Multiply that by six months, take 80% of the total, and you end up with a hefty prepayment penalty of $13,000.

An example of a prepayment penalty:

$500,000 loan amount
Interest rate of 6.5%
Monthly mortgage payment of $2,708.33
6 monthly payments = $16,249.99
80% of those 6 monthly payments = $13,000.00

Needs of the prepay,

• Prepayment penalties protect the lender/investor who purchases the loan
• From early prepayment associated with a refinance or home sale
• Since they won’t make as much money on the loan
• Assuming it isn’t kept until maturity, or worse, paid off almost immediately
• But this also means the interest rate might be lower for the borrower

Prepayment penalties were devised to protect lenders and investors that rely on years and years of lucrative interest payments to make money.

When mortgage loans are paid off quickly, regardless of whether by refinance or a home sale, less money than originally anticipated will be made. It’s a simple concept.

The mortgage is extended with the belief that a certain amount of interest will be collected. If in reality, much less is realized, the holders of these mortgages won’t profit as they originally expected. So it’s clearly less desirable for those who hold the loan.

This is essentially a way for those with an interest in your mortgage to ensure they get something back, regardless of how long the mortgage is kept before being paid off.

The good news, if you’re a borrower, is that a mortgage with a prepayment penalty attached should come with a slightly lower interest rate, all things being equal.

After all, it’s more restrictive in nature, so the price should be lower as a result.

This is similar to how an ARM prices lower than a fixed-rate mortgage, since you’re taking a risk of a rate reset with the former.

Prepayment Penalties

• While they are far less common these days
• They still exist on certain home loans
• Such as non-QM loans and other portfolio loans
• So always check your paperwork!

Be careful when considering a mortgage with a prepayment penalty. While not as common today as they were in the early 2000s, they may still be tacked onto mortgages offered by portfolio lenders, who set their own rules.

Although a mortgage with a prepayment penalty may come with a much lower interest rate, it can come back to haunt you if you need to refinance earlier than planned, if mortgage rates drop significantly, or if you decide to sell your home earlier than you anticipated.