The faster you pay off your mortgage, the less interest you pay. Because lenders like to make money off the mortgage loan, many mortgage contracts include a prepayment penalty. The penalty kicks in if you pay off the mortgage too soon for your lender's taste. They're particularly popular with lenders offering adjustable-rate mortgages, so that you can't refinance before the rate adjusts upward.
Lenders don't usually penalize you for paying making a month or two of extra payments every year: Usually you can prepay up to 20 percent of your mortgage annually without problems. What scares your lender is the possibility you'll refinance or sell and avoid years of interest. If your mortgage includes a "hard" prepayment penalty, you pay if you sell the house or refinance the mortgage. A "soft" penalty applies only to refinancing.
Most mortgages end the prepayment penalty within five years of the date you bought the house. If you refinance within that period, the lender typically adds up six months' worth of interest, calculates 80 percent of the total, and then sends the result to you as your penalty. Some lenders charge 2 or 3 percent of the loan balance instead. If your loan is insured by the Federal Housing Administration or the Veterans Administration, your lender can't penalize you for prepayment. Mortgages from federally chartered credit unions can't include penalties either.
Prepayment penalties aren't all bad. If you're a good credit risk and a desirable customer, your lender may be happy to make concessions -- a cut in your interest rate, for instance -- if you agree to give the bank the security of a prepayment penalty. If that's the case, weigh the gains against the risks of paying the penalty: If it's not too steep and only applies to the first few years, it might be worth it.
If your credit is poor and your down payment small, you may have to settle for whatever terms you can get. In that case, your lender may throw in a prepayment-penalty clause without bothering to tell you. When you close, your loan documents have to include a truth-in-lending statement that tells you you if there's a prepayment penalty. Unfortunately, as you have a pile of papers to sign, it's very easy to miss the statement and get blindsided later.