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Four Things to Understand About Prepayment Penalties by John Steely
If you have a mortgage,[link widoczny dla zalogowanych], of any type, many people will give you the advice to make extra payments on the mortgage in order to pay off the mortgage that much sooner. Indeed, depending on the interest rate of the mortgage, making extra payments has a return in line with the best money market accounts. And you get debt free that much sooner. Whether or not you should pay extra on your mortgage depends on many factors, and there are many articles written about doing that; one of the factors involved is whether there are prepayment penalties in your mortgage or not.
So, if you are going to make an informed decision about paying off your mortgage early, whether through extra payments or through refinancing your mortgage (which mortgage companies would love for you to do), you need to understand what prepayment penalties are, how they work, and why do they exist.
Types of Prepayment Penalties
If your mortgage has prepayment penalties, they are in place for a period of time at the beginning of the mortgage. That period of time is anywhere from two to five years; after that period is done, the penalty no longer applies. The reason the prepayment penalty only exists for the first few years of the mortgage is because the mortgage company has incurred certain expenses in making the mortgage, above and beyond what you are charged when the mortgage is closed. One example of such expenses is the commissions paid to the people involved in originating the mortgage. The mortgage company wants to make sure they get enough interest to cover such expenses, so if you pay off the mortgage too early, they will put a prepayment penalty to collect enough money to cover such expenses.
There are two types of prepayment penalties. The hard prepayment penalty is one that is charged regardless of how the loan is paid off. No matter what the circumstances, a hard prepayment penalty will be charged in addition to the monies needed to pay off the principal. The soft prepayment will not be charged under certain conditions; the two most common ways to avoid a soft prepayment penalty are either to sell the house or to refinance the mortgage through the original lender. If you simply put enough extra money into the mortgage or if you refinance through another company, the soft prepayment penalty will be charged.
How is the Penalty Calculated
Prepayment penalties will be triggered when one of two conditions is met; the mortgage must specify which conditions apply. The first type of penalty will is called a first dollar penalty,[link widoczny dla zalogowanych], and it will be triggered whenever any extra money is applied to the principal. The usual calculation with this type of penalty is 80% of the interest owed on the extra money. Let us say you have a loan at 7% and you put an extra $100 on the principal one month. This type of penalty will charge you 80% of the 7% interest due on the extra $100, or $5. 60. The exact details are in your mortgage. This penalty will be due every time you make extra payments on the principal.
The second type of penalty is called the 20% penalty. In this case, the penalty is triggered when you have paid an extra 20% of the principal. Again, let us say you have a mortgage of $150, 000 at 7% interest. With this penalty, nothing will be charged until you have made extra payments totaling $30, 000. When this amount is reached, you will be charged 6 months interest on 80% of the remaining principal. For example, let say in the above mortgage you made regular payments and reduced the principal down to $140, 000, and then you came into an inheritance and put $30, 000 on the loan, thus reducing the principal down to $110, 000. Your penalty will be 6 months interest of 7% on $88, 000,[link widoczny dla zalogowanych], or $3,[link widoczny dla zalogowanych], 080. This penalty will be due the first time the trigger event occurs, but only the first time.
Many states put a cap on the size of the prepayment penalty. For example, my state, Virginia, has a cap of 2% of the owing principal as a penalty.
Why should I accept a Prepayment Penalty
Many people will tell you to never accept a mortgage with a prepayment penalty of any type; they will tell you it limits your options. However, the mortgage company will compensate you for a prepayment penalty in one of two ways; they will either reduce the interest rate of the mortgage by, say, half a percentage point, which could save you several thousand dollars over the life time of the mortgage, or they will reduce the loan points at the time of closing by one or two points, which again can save you a couple of thousand dollars.
The issue is where you see yourself heading. If you are planning on moving in the period covered by the prepayment penalty, then it may be worth your while to accept the higher rate or points so that you will not incur the penalty. If you are comfortable with the idea of not moving during the prepayment penalty period of two to five years, take the penalty and the lower rate and/or points.
Explicit Penalties Only
In either case, whether you have a mortgage now or not, the prepayment penalties must be spelled out in detail in the mortgage contract. If you are unsure, have a financial professional look at the mortgage; such a professional is trained at understanding this type of clause.
If someone comes to you with a deal, particularly a refinancing deal, make sure you know what you would have to pay before you accept the promised loan. You may be surprised to find all your supposed savings eaten up by these kinds of penalties and fees. A lower rate does not always make the best deal.
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