Prepayment Penalty Dangers and Mortgage Calculators

Prepayment penalties are penalties for paying a home loan off very early in the term.  Most home loans do not carry prepayment penalties but for those that do, can be costly.  The penalty is generally a percentage of the outstanding loan balance.  Most prepayment penalties are for three years but some run as long as five years.  The brutality of the prepayment penalty may also vary.  Three to five percent of the outstanding mortgage balances are common.  Many prepayment penalties will decrease in severity over time.  For instance the first year maybe five percent then the fourth year it drops down to four percent then the third year its three percent until the end of the fifth year when the penalty would no longer exist. 

Prepayment penalties can be classified as hard penalties or soft.  Soft prepayment penalties are penalties that would be waived it you should sell the house even within the prepayment term.  The opposite, is the hard prepayment penalty.  In these cases the penalty is enforced regardless of the reason for prepaying the loan during the penalty term.  Running a mortgage calculator scenario that saves money for a new refinance can quickly be turned upside down once a borrower discovers their home loan has a prepayment penalty.

These terms of a mortgage prepayment penalty can be a costly burden should you want to refinance the loan within the prepayment period or sell the house with a hard prepayment penalty.  In time of rising mortgage rates and adjustable rate mortgages that are resetting, a borrower would be far better off to have the option of altering the loan without the danger of a prepayment hanging over.  If a loan does have a prepayment penalty and the homeowner is considering a new refinance, it is imperative that the costs of the prepayment penalty be added to the total cost of the loan in the mortgage calculator in order to know the full cost of the new mortgage transaction.

Most prepayment penalties were established to protect the rate of return for the mortgage company.  The prevailing wisdom is that a prepayment penalty locks in the interest rate the mortgage company will receive for at least some period of time.  With the prepayment penalty in place a mortgage lender is guaranteed a minimum rate of return.  Prepayment penalties are more commonly found on subprime loan products.  With a subprime loan, a borrower who was able to improve his or hers credit would almost immediately benefit by prepaying a subprime loan for better terms.  For a conforming borrower, they are likely to prepay only when the terms of a new loan are more desirable via lower rates. 

The benefit of having a prepayment penalty is that the loan you receive with the penalty will have a lower mortgage rate than on without.  In addition, since a subprime borrower has the most to gain and the lender the most to lose on early payoffs, you may find you can not obtain a subprime loan without a prepayment penalty.  Always shop and compare mortgage options.  If there home loans without a prepayment penalty, it is almost always a better choice to select the mortgage loan that does not have a prepayment penalty.  If it is a question of different mortgage rates, a high mortgage rate without the prepayment penalty and a lower rate with a penalty, be sure to use the mortgage calculators to compare monthly payments and to total costs.  The mortgage calculator can display an amortization schedule to help determine the costs over the life of the loan and the balance of the loan at future date to ascertain the cost of the prepayment should you need to refinance the loan.

At the time of this article, prepayment penalties are causing added stress to the difficulties in the subprime market.  Many state legislatures as well as the US Congress are considering options restricting the terms on prepayment penalties or eliminating them altogether.  If you are applying for a loan now that has a prepayment penalty, do your best to negotiate the terms.  Always try and avoid the prepayment penalty.  If that fails work on the shortest time frame that the penalty will be enforced and the lowest penalty amount.  Use the mortgage calculators to help investigate all the loan terms and options that are available.  Know your options, understand the conditions and never sign the paperwork until you are satisfied.

Tags: mortgage amortization, mortgage calculator, mortgage prepayment, mortgage rates, mortgages

This entry was posted on Monday, March 16th, 2009 at 7:23 pm and is filed under Mortgage Basics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.