Did you know that you could be penalized for paying a mortgage more quickly than necessary? It’s true. This is what’s known as a prepayment penalty, and it’s fairly common on home equity loans and lines of credit, though less so on first mortgages. However, the high-risk mortgages that are now in the news so much often have prepayment penalties, too.
The way the prepayment penalty works is that a lender offers you a loan with various terms. Let’s say it is $100,000 at 10% interest for 30 years. Somewhere in the document is buried a statement that you will be charged a penalty if you pay the loan off in less than 30 years. And thus, if you pay early, you will be hit with this fee. It’s usually about 5% of the original amount of the loan, so for a $100,000 loan, that would be $5,000. That’s a nice chunk of change.
To be fair to lenders, they often have a legitimate reason for including prepayment penalties. Basically, they arise when the lender has offered you a good introductory rate or not charged you any type of original fee. That’s why you see these a lot on home equity loans that have no fee. By having this prepayment penalty, the lender makes sure that its up-front costs are covered if you don’t hold the loan for very long. Once those costs have been captured, you are free to do as you wish. So you often see with home equity loans, for example, that you will face a prepayment penalty if you pay off the account in two years or less.
For similar reasons, these high risk loans that Congress is holding hearings about also have prepayment penalties. In this case it’s because they offer ridiculously low introductory interest rates so that people can qualify for the payments. The lender is losing money on the loan for a couple of years. But the lender makes it up – and makes tons of profits – after the first couple of years. So the lender is afraid that people will take the ultra-low rate and then jump to another lender right when the rate rises. To avoid that occurrence, they stick in prepayment penalties. And the borrower is stuck.
There is absolutely nothing illegal or even unethical about prepayment penalties. But they need to be disclosed clearly, and you need to think about the possible implications. If you are buying a house that you think you won’t live in for more than five years, but the loan has a 10-year prepayment penalty, then you should ask for a loan with different terms. Any reputable lender will have many options for you to choose from, and you pick the one that works best for you.