You may think that prepaying your mortgage is a very good thing. After all, it shows you have the cash and motivation to pay your debts aggressively. But in some cases it can be a problem—especially if you plan to pay a significant amount of your debt ahead of time. This is because the mortgage company may charge a prepayment penalty. It's important to check your mortgage paperwork for a prepayment clause before you close a loan. If it does apply, calculating the penalty is fairly straightforward—you can probably do it by hand.
Determine your annual principal pay-off allowance for the loan. This is outlined in your mortgage paperwork. Sometimes it's a flat fee, and in other cases, it's a percentage of the current balance. This is the total amount of principal you're allowed to pay off each year without a penalty. For an example, use $10,000 per year principal pay-off allowance.
Check your latest mortgage statement to determine the current unpaid balance. To be sure, you may want to simply call your mortgage company to find out the exact balance. Subtract the pay-off allowance from the current unpaid balance. Say the amount left to pay off on the mortgage is $85,000, the result (called your prepayment principal) is $75,000.
Multiply the result by your interest rate to get the total interest charge for the year based on that prepayment principal. If your rate is seven percent the total interest rate for the year is $5,250 (.07 * 75000). Divide that figure by 12 to get the average monthly interest charge ($437.50 in this case).
Multiply the result of that average monthly interest charge by the number of months you're charged as a condition of the prepayment penalty. The number of months is commonly about six months. So in this example, the total prepayment penalty is $2,625 (six times $437.50).
- Keep in mind that the calculation requirements for each lender may vary. For instance, in some cases the lender may charge a flat percentage of the initial principal balance as the penalty. Examine your mortgage paperwork thoroughly to determine the exact rules for calculating your prepayment penalty.