A prepayment penalty is a fee that applies to some mortgages if you pay all or part of your loan early. Most mortgages are sold in the secondary market such as to Fannie Mae (FNMA) or Freddie Mac (FHLMC). The penalty is an incentive for borrowers to pay back their principal over a longer term. This allows the mortgage purchaser more certainty of their continued investment.
If applicable, most penalties are in place for about five years. When a borrower pays off more than 20% of their loan balance in a one-year period. Let’s assume you owned a home and were to get a job transfer in year two of your mortgage. If you sold your home you would have to pay a penalty. Another example is that if interest rates were to drop and you hoped to refinance, again there would be a penalty.
Potential home buyers and homeowners hoping to refinance should beware of prepayment penalty clauses. They were not common when interest rates were in the twos and threes. However, now that rates have climbed, they are a tool more often used by banks. When loan shopping, make it clear that there will not be a prepayment penalty. Be sure that the information you have been provided verbally is apparent in the contract you will be signing with the lender. If needed, get your lender on the phone and ask them precisely where you can find the information noting there is no prepayment penalty.