It seems a little perverse to penalize a virtuous act, but that’s what can happen if you get slapped with a penalty for getting out of debt early by prepaying a mortgage. The good news is that mortgages originating in 2014 or after cannot charge prepayment penalties except under limited circumstances. However, older mortgage agreements may include a prepayment penalty clause with a more substantial bite.
Read the Prepayment Penalty Disclosure
Your mortgage loan estimate, as well as the closing documents, will include a disclosure for any prepayment penalty that applies. Read and understand the disclosure so that you can plan your future mortgage payment strategy. The mortgage industry uses three basic methods for calculating prepayment penalties:
- The percent of principal method
- The percent of interest method
- The interest rate differential method
Typically, you will need to verify the remaining principal balance on your mortgage. You may also need to verify the loan’s interest rate and the terms spelled out in the mortgage’s prepayment penalty clause.
Percent of Principal Method
The percent of principal method is the only method lenders can use on most mortgages issued on or after Jan 10, 2014. The Dodd-Frank Act requires that fixed-rate, qualified mortgages issued on or after that date can impose prepayment penalties for only the first three years of the loan, and for no more than 2 percent of principal balance.
The method is so simple that you don’t need a prepayment penalty calculator. All you do is multiply your remaining principal balance by the penalty percentage to calculate the fee. For example, if you owe $200,000 on your mortgage and a 2 percent penalty applies, you’ll be charged a fee of $200,000 x 0.02, or $4,000.
Percent of Interest Method
This method assesses a percentage of the interest you would have incurred over a set period had you not prepaid the mortgage. For example, the penalty clause may specify a fee equal to 80 percent of six-month’s interest. Suppose you owe $200,000 and have a mortgage with an annual 6 percent interest rate. Therefore, the interest charge is 3 percent for the six-month period, and $200,000 x 0.03 is $6,000. Multiply by 80 percent (0.80 x $6,000) to get the penalty amount of $4,800.
Interest Rate Differential Method
Under the IRDM, you pay a fee based on the decrease of mortgage interest rates since you closed on your loan. For example, if you owe $200,000 on a loan with 6 percent interest and the lender currently charges 4 percent, you pay a 2 percent, or $4,000, penalty. The bank might charge a fixed percentage or flat fee if interest rates have risen since you took out your loan.
Prepaying Over Time
You may decide to prepay your mortgage slowly rather than with one lump sum. For example, you might want to pay off a 30-year mortgage in 15 years. It’s important that you check with your lender, because some mortgages allow a certain amount of annual prepayment without penalty. You can use an online mortgage prepayment calculator to figure how much extra to pay each month to cut your mortgage payoff period from 30 to 15 years.
Monthly Prepayment Example
For example, suppose you want to begin monthly prepayments on a new $200,000, 30-year mortgage charging 6 percent interest. Enter the following information into the calculator:
- Loan amount: $200,000
- Interest rate: 6 percent
- Loan term remaining: 360 months
- Loan term shortened to: 180 months
Your current monthly payment is $1,199.11. The calculator will reveal that you can repay the loan in 15 years by adding $523.14 to your monthly payment, bringing it to $1,722.25/month. You’ll also learn that your plan will reduce your total interest cost by $125,851.48.
Finally, check with your lender to see if it will charge a penalty on the monthly prepayment of $523.14. You might need to reduce your extra monthly payment amount to avoid a prepayment penalty.
- 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.