In the early years of a mortgage, most of the payment is applied towards the interest. You can pay off your loan early, but it won't necessarily eliminate the interest fees. Lenders devised prepayment penalties to protect themselves from losing out on lucrative interest earnings. If you are penalized, the IRS allows you to deduct prepayment penalties on your tax return.
When Prepayment Penalties Occur
A prepayment penalty is imposed when you pay off your loan early. Selling the home, refinancing or just paying off your loan ahead of schedule can potentially leave you with a fine to pay. There are two different types of penalties lenders may charge. A soft prepayment penalty is only assessed when the borrower refinances. With a hard prepayment, the borrower is charged the penalty regardless of how the loan is paid off early.
Qualifying for the Deduction
To deduct the entire prepayment penalty in one year, you must pay the penalty in full. If you refinance and roll the penalty into your new loan, you can deduct the penalty over the life of the loan. For borrowers who refinance but choose to pay the prepayment penalty at closing, the entire penalty is deductible.
Reporting the Deduction
Typically, the prepayment penalty is equal to a percentage of the remaining interest you would pay over the course of the loan. If the loan is for your primary residence or secondary home, report the deduction on Schedule A as home-mortgage interest. If the loan is for a rental home, the interest is deducted on Schedule E. To claim the expense, you must itemize.
Avoiding the Prepayment Penalty
Prepayment penalties decline and vanish completely after a few years. Typically, mortgages contain a prepayment clause that only applies if the loan is paid off within three or five years of the loan's origination. Prepayment penalties are rarely seen after five years. Lenders also accept partial prepayments of up to 20 percent of the balance each year without charging a penalty.