No matter how euphoric shopping for your dream home is, finding the right mortgage will bring you right back to reality. You will need to choose between a fixed rate or adjustable rate, longer term or shorter term, and a host of other variables tossed in by the lender to make their mortgage more attractive. If you do not plan on staying in your new home long term, one critical piece of information is whether your mortgage comes with a prepayment penalty clause.
Mortgages are loans used to purchase real estate. When you take out a mortgage, you enter into a contract with the lender to pay back the original amount of the loan plus accrued interest according to a set repayment schedule. The length of time that a lender uses to calculate interest is called a “term.” A 30-year fixed-rate mortgage has a term of 30 years, while an adjustable-rate mortgage, or ARM, with a five-year fixed-rate period followed by 25 years of variable interest has a five-year term followed by a 25-year term. A mortgage’s maturity date is the date that the entire balance of the loan is due.
Definition of a Prepayment Penalty
A prepayment penalty mortgage, or PPM, includes a clause that allows the lender to charge substantial penalties and fees if you pay back all or part of the original loan amount before the mortgage’s maturity date, excluding the normal amounts of principal repaid through the lender’s payment schedule. Although each lender’s clause may differ, prepayment could include additional payments towards principal during the mortgage term, refinancing the house, or selling the home before the maturity date.
Many lenders do not consider the sale of the home a prepayment, while others do, and some financial institutions allow partial prepayments of up to a certain percentage each year without the penalty coming into play. When lenders do impose the penalty, however, the amount may be a small percentage of the original loan balance, or it can be up to six months or more of interest payments. Most prepayment penalties diminish over a period of time or disappear altogether after a set time period, usually three to five years.
Benefits of a PPM
When you prepay any portion of a mortgage, lenders lose out on interest that the loan would have accrued if it went until its maturity date. Lenders usually try to make PPM clauses more appealing to borrowers by offering lower fees and reduced interest rates for those who choose them. Although many home buyers do not plan to be in their home for the entire mortgage term, if you do plan on staying put for at least the period that the PPM comes into play, adding this clause to your mortgage could prove beneficial.
On the Legal Side
As of 2010, only 36 states and the District of Columbia allow lenders to charge prepayment penalties on home mortgages. If you do not live in a state that allows PPMs, you may still incur one when you try to refinance as many federally chartered lending institutions do not believe they are subject to the laws of the individual states. In June of 2010, for example, Liz Kay of “The Baltimore Sun” reported that Maryland state financial regulators ordered several mortgage companies to refund what they considered illegally obtained prepayment penalties to the consumers.
Read the Fine Print
Your lender will present you with a set of papers when closing on your mortgage that includes a Truth in Lending statement, or TIL, which sometimes uses vague language. You can find the PPM statement towards the bottom of the document. If you or the lender has checked a box that says the mortgage “may” be subject to a prepayment penalty, that means your mortgage is subject to a prepayment penalty.
- Freddie Mac: Borrower Information Guide to Prepayment Penalty Mortgages (PDF)
- U.S. Department of Housing and Urban Development: Glossary
- The Mortgage Professor: Mortgage Prepayment by Doubling Principal
- Lending Tree: Prepayment Premium
- The Mortgage Professor: Disclosure Rules on Mortgage Prepayment Penalties
- "The Baltimore Sun"; Mortgage Servicers Refunded Prepayment Penalties; Liz F. Kay; June, 2010
- Jupiterimages/BananaStock/Getty Images