Mortgage Refinance Penalties

Lenders don't generally appreciate borrowers paying off their mortgages early. Paying early translates into lost income from interest payments. Lenders will go as far as to discourage clients from refinancing by including prepayment penalty clauses in their mortgage agreements. If a lender only charges a prepayment penalty if you refinance, it is called a soft penalty. If the lender charges the penalty regardless of the reason you prepay -- such as selling your home -- it is called a hard penalty.

While prepayment penalties vary in cost, they never come cheap. Consider them a banker's version of a prenuptial agreement: They are designed to keep you loyal or pay the price. According to a report by the Maine Office of Consumer Credit Regulation, a typical prepayment penalty will set you back 5 percent of the loan's balance. To illustrate, if you refinance a $100,000 mortgage and you have a 5 percent prepayment penalty, it will cost you $5,000 just to get from under your existing mortgage.

Prepayment penalties form a thorny issue in the lending industry. Some consider them to represent a predatory lending technique, which is why in many states they are either illegal or strictly regulated. Alaska, Hawaii, Iowa, New Jersey, Oklahoma and Kansas prohibit lenders from charging prepayment penalties. Other states, such as Colorado, California, Illinois, Indiana, Michigan and Minnesota, allow prepayment penalties but restrict their use after the first 24 months of a loan. On the other hand, loans insured by the federal government -- such as Freddie Mae, Freddie Mac and FHA loans -- are not allowed to charge prepayment penalties on their loans, regardless of state law.

The silver lining of a mortgage prepayment penalty is you can declare the cost as part of your regular mortgage interest tax deduction. When you file your tax return, include the prepayment penalty on line 10 of Schedule A of your Form 1098. This allowance does not apply if the lender charges you a penalty for a specific service related to your mortgage, such as reducing the interest rate of the refinancing mortgage.