Prepayment Penalty
Fee charged by lenders for paying off mortgage early; limits refinancing flexibility.
Key Takeaways
- Start by grasping the core concepts and workflows
- Confirm the latest regulations and requirements from official sources
- Consult experienced practitioners for tailored recommendations
Overview
A prepayment penalty is a fee charged by lenders when a borrower pays off a mortgage loan early, either through refinancing, selling the property, or making extra payments that exceed a certain threshold. The penalty is designed to compensate lenders for lost interest income and is typically outlined in the mortgage contract.
How Prepayment Penalties Work
- Penalty period: Typically 2-5 years from loan origination
- Penalty amount: Usually 2-5% of the remaining loan balance
- Graduated penalties: May decrease over time (e.g., 5% year 1, 4% year 2, etc.)
- Limited prepayment: Many loans allow 10-20% prepayment without penalty
Types of Prepayment Penalties
- Hard Prepayment Penalty: Applies to any prepayment over the allowed limit
- Soft Prepayment Penalty: Only applies to refinancing, not to selling the home
- Yield Maintenance: Calculated to ensure lender receives expected yield
US vs Canada Prepayment Rules
In the US, prepayment penalties are regulated and are less common today, especially for conventional loans. In Canada, prepayment penalties are more common, particularly for fixed-rate mortgages, and can be substantial. Canadian lenders often use the "greater of" calculation: either three months' interest or the interest rate differential.
Related Glossary Terms
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