Hidden Cost of Prepayment Penalties
We recently interviewed Kurt Beshore, loan officer with Horizon Farm Credit. Kurt discusses prepayment penalties, including what they are and how to avoid the hidden costs associated with them.
Let’s start with the basics. What is a prepayment penalty, and how does someone know if they have a prepayment penalty condition on their loan?
A prepayment penalty is a clause in the mortgage contract that states a penalty may be assessed by the lender if the borrower significantly pays down or pays off the mortgage before the term of the loan.
Typically prepayment penalties occur during the beginning of the loan and also during a time where interest rate is fixed for a set period. There's typically a section in the note that the borrower signs that lists the clauses, and there's typically section in that, that spells out specifically what the prepayment penalty is, whether it's a percentage or fee in a set period of months that the prepayment penalty can be assessed.
If there is a prepayment penalty on their loan, what is important for the borrower to know?
The two big things I'll discuss are the cost and the options that you have.
First on cost – I’ll talk about three common approaches that we see to prepayment penalties:
- Step down: It starts as a 5% fee in the first year, 4% in the second year and so on until you get to 0% after the fifth year. Normally, that is in conjunction with a five-year fixed interest rate.
- Percent balance: Typically, it's 2% of the principal balance of the loan.
- Straight fee: We don’t see this very often, but it is a straight dollar amount associated with prepaying the loan early.
Now let’s talk about options for borrowers. There are a few options you have in terms of prepayment penalties:
- You can simply just ride out the current interest rate you have. It's not going to cost you anything to do that. I know you're going to be stuck there, but it's one of the options you have.
- Refinance with your existing lender. Sometimes they might be willing to waive or reduce the prepayment penalty.
- Refinance with another bank. Run the numbers and make sure it's cost effective for you to do so.
- Ask the lender you're refinancing way if they have any sort of creative solutions to help with the prepayment penalty. There could be options out there from other lenders who may be willing to help you through that situation.
Is there anything else you’d like to share with listeners on this topic?
A prepayment penalty is a true cost to the borrower, so when you're considering interest rates and there is a prepayment penalty, there needs to be some sort of cost associated with that. Typically, we say it does add a premium to the rate just because it limits the flexibility that you have as a borrower if you're locked in on terms and rates.
We don't know what the future holds, and the prepayment penalty could be a limiting factor for your borrowing capacity moving forward. When you are looking through your loan documents, if you have a prepayment penalty, make sure you fully understand it.
Know that you don't have to accept prepayment penalties. There are lenders out there who offer loans without prepayment penalties. You can ask your lender to exclude prepayment penalties.
Understand the true cost of what the prepayment penalty does for you, and also understand that you have options to not include a prepayment penalty in your note.