A prepayment penalty is a fee charged when you pay off your mortgage early, either by refinancing or selling. Most residential mortgages originated after 2014 don’t have prepayment penalties due to federal regulations. When they exist, penalties typically range from 2-5% of the remaining balance or 6 months of interest, and usually only apply during the first 3-5 years. Check your loan documents or call your servicer to verify if your loan has one.
What Is a Prepayment Penalty?
The Basic Concept
A prepayment penalty compensates lenders for lost interest when you pay off early. Lenders expected to earn interest over 30 years—if you pay off in year 3, they lose 27 years of expected income.
Types of Prepayment Penalties
Hard prepayment penalty:
- Applies to any early payoff
- Refinancing or selling triggers it
- Most restrictive
Soft prepayment penalty:
- Applies only to refinancing
- Selling the home doesn’t trigger it
- More common when penalties exist
When They Apply
Penalties typically apply when:
- Paying off the entire loan early
- Refinancing to a new loan
- Selling the home (hard penalty only)
- Paying more than a certain percentage annually
Penalties typically don’t apply to:
- Regular extra principal payments (within limits)
- Biweekly payments
- Small additional payments
- Payoff after the penalty period ends
How Prepayment Penalties Are Calculated
Common Calculation Methods
Percentage of balance:
- Fixed percentage of remaining principal
- Example: 2% of $300,000 = $6,000
Months of interest:
- Typically 3-6 months of interest
- Example: 6 months at 6% on $300,000 = $9,000
Sliding scale:
- Decreases over time
- Year 1: 5%, Year 2: 4%, Year 3: 3%, etc.
Example Penalties
$350,000 loan at 7%:
| Calculation Method | Penalty Amount |
|---|---|
| 2% of balance | $7,000 |
| 3% of balance | $10,500 |
| 3 months interest | $6,125 |
| 6 months interest | $12,250 |
When Prepayment Penalties Exist
Loan Types With Penalties
May have penalties:
- Non-QM loans
- Subprime loans
- Some commercial loans
- Hard money loans
- Private lender loans
- Some older loans (pre-2014)
Rarely have penalties:
- Qualified Mortgages (QM)
- FHA loans
- VA loans
- USDA loans
- Conventional loans (post-2014)
The Qualified Mortgage Rule
Since 2014, most residential mortgages are “Qualified Mortgages” (QM) that cannot have prepayment penalties lasting more than 3 years or exceeding 2% in the first 2 years.
QM prepayment penalty limits:
- Year 1: Maximum 2%
- Year 2: Maximum 2%
- Year 3: Maximum 1%
- Year 4+: No penalty allowed
Penalty-Free Loan Types
FHA, VA, USDA:
- Never have prepayment penalties
- Can pay off anytime without penalty
Most conventional (post-2014):
- QM rules apply
- Most have no penalty at all
- Some have limited 3-year penalty
How to Find Your Prepayment Penalty
Check Your Loan Documents
Where to look:
- Promissory note
- Loan estimate (for newer loans)
- Closing disclosure
- Original loan documents
Search for terms like:
- “Prepayment”
- “Early payoff”
- “Penalty”
- “Premium”
Call Your Servicer
Ask specifically:
- Does my loan have a prepayment penalty?
- What triggers the penalty?
- How is it calculated?
- When does it expire?
Request a Payoff Quote
A payoff quote shows:
- Current balance
- Accrued interest
- Any prepayment penalty
- Total to pay off
Avoiding Prepayment Penalties
Before You Get the Loan
During shopping:
- Ask about prepayment penalties upfront
- Compare loans with and without penalties
- Understand the trade-off (sometimes lower rate for penalty)
Before signing:
- Read the promissory note carefully
- Ask the loan officer to explain
- Know when penalty expires
After You Have the Loan
If penalty exists:
- Know when it expires
- Time refinancing or sale accordingly
- Calculate if penalty is worth it
Making extra payments:
- Check if limits apply (often 20% per year allowed)
- Stay within limits
- Pay off when penalty expires
When Paying the Penalty Makes Sense
The Math
Compare penalty cost to savings from refinancing or other action.
Example:
- Penalty: $6,000
- Monthly payment savings from refinance: $300
- Break-even: 20 months
If you’ll keep the new loan 20+ months, paying the penalty makes sense.
Consider These Factors
Time remaining on penalty:
- 6 months left? Maybe wait.
- 24 months left? Probably pay penalty.
Rate difference:
- 1% lower? Significant savings.
- 0.25% lower? May not be worth it.
How long you’ll keep new loan:
- Staying 10 years? Penalty is minor.
- Moving in 2 years? Penalty matters more.
Extra Payments and Prepayment Penalties
What’s Usually Allowed
Most loans with prepayment penalties still allow:
- 10-20% extra principal per year
- Regular additional payments
- Biweekly payment plans
What Triggers the Penalty
Typically only:
- Paying off the entire balance
- Paying off more than allowed annually (if limits exist)
- Refinancing
Check Your Specific Terms
Read your loan documents for:
- Annual prepayment limits
- Definition of “prepayment”
- Exceptions and carve-outs
State Regulations
States With Additional Protections
Some states limit prepayment penalties beyond federal rules:
| State | Restriction |
|---|---|
| California | Various consumer protections |
| Colorado | Limits on adjustable-rate loans |
| Florida | Specific disclosure requirements |
| Texas | Various limitations |
| New York | Consumer protection laws |
Federal Baseline
All states must follow federal QM rules at minimum:
- 3-year maximum penalty period
- Maximum 2% in first 2 years
- Maximum 1% in year 3
- Applies to most residential mortgages
Prepayment Penalties and Refinancing
Factor Into Your Decision
Refinance calculation should include:
- Closing costs of new loan
- Any prepayment penalty
- Monthly savings
- Time to break even
Example Decision
Current loan:
- Balance: $280,000
- Rate: 7.5%
- Prepayment penalty: $5,600 (2%)
New loan:
- Rate: 6.5%
- Closing costs: $6,000
- Monthly savings: $200
Total cost to refinance: $11,600 Monthly savings: $200 Break-even: 58 months (about 5 years)
Worth it if staying 5+ years.
Prepayment Penalties and Selling
Soft vs Hard Penalties
Soft penalty: Doesn’t apply when selling—only refinancing
Hard penalty: Applies to any payoff, including sale
Impact on Sale
If hard penalty exists:
- Factor into net proceeds calculation
- May affect timing of sale
- Consider waiting if penalty expires soon
Commercial vs Residential
Commercial Loan Penalties
Much more common:
- Yield maintenance (very expensive)
- Defeasance (complex process)
- Step-down penalties
- Lockout periods (no prepayment allowed)
Why Commercial Is Different
Commercial loans are investment products:
- Investors expect specific returns
- Prepayment disrupts cash flow
- More complex penalty structures
If You Have Commercial Property
Always check prepayment terms before:
- Refinancing
- Selling
- Making large paydowns
Negotiating Prepayment Penalties
Before Getting the Loan
You may be able to:
- Choose a loan without penalty
- Accept penalty for lower rate
- Negotiate penalty terms
Trade-offs:
- No penalty: Slightly higher rate
- With penalty: Slightly lower rate
- Your choice depends on plans
After Getting the Loan
Options are limited:
- Can’t usually remove penalty
- Wait for expiration
- Refinance anyway if worth it
Frequently Asked Questions
Do most mortgages have prepayment penalties?
No. Most residential mortgages originated after 2014 don’t have prepayment penalties. The Qualified Mortgage (QM) rule limits them significantly.
How do I know if I have a prepayment penalty?
Check your promissory note and closing disclosure. Look for sections on “prepayment” or “early payoff.” Or call your servicer and ask directly.
Can I make extra payments without penalty?
Usually yes. Most loans allow extra principal payments. Even loans with prepayment penalties typically allow 10-20% extra per year. Check your specific terms.
How long do prepayment penalties last?
When they exist, typically 3-5 years. By law (for QM loans), they cannot exceed 3 years and must decrease over time.
Can I sell my house if there’s a prepayment penalty?
Yes. If it’s a “soft” penalty, selling doesn’t trigger it. If it’s a “hard” penalty, the fee will come from your sale proceeds.
Should I avoid loans with prepayment penalties?
Generally yes, unless the rate benefit is significant and you’re confident you won’t refinance or sell during the penalty period.
Do FHA and VA loans have prepayment penalties?
No. FHA, VA and USDA loans never have prepayment penalties. You can pay them off anytime without penalty.
Sarah Mitchell
Licensed Mortgage Broker, 15+ Years Experience
Our team of mortgage experts provides accurate, up-to-date information to help you make informed decisions about your home financing.
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