Even though your intentions are good, some lenders charge a fee if you pay too much extra on the principal of your home equity loan each month. The really bad news is that prepayment penalties can prevent you from paying off the loan early. Paying more on the principal essentially leads to paying off what you owe before the term of the loan is up, and that means the lender loses money.
Some home equity loans have prepayment penalties, and others don't. Loan terms vary, depending on the type of loan and the lender, so review your loan paperwork before signing on the dotted line and discuss the prepayment with your lender.
Prepayment Penalty Disclosure
You can discover a home equity loan prepayment penalty by asking your lender or reviewing your loan paperwork. You may be able to negotiate a lower penalty rate or even a waiver of the fee by agreeing to go with that same lender if you ever decide to refinance the loan. Prepayment penalties vary among lenders.
Some lenders charge a fixed fee; others decrease the rate the longer you pay on the loan. Banks generally base a prepayment penalty on a certain percentage of the initial balance of the loan or the amount of interest you pay for a specific number of months.
Before signing on the dotted line, read the prepayment penalty disclosure carefully. If you don’t know what you’re in for, paying off the balance you owe early can significantly increase the total cost of the loan.
Negotiating With the Lender
If you are thinking about selling or refinancing your home and your loan documents contain a prepayment penalty provision, one option is to talk to your lender. See if the lender will agree to remove the stipulation from your loan. Although you may have to pay a higher interest rate or more points in return when you refinance the loan, it may cost you less than the prepayment penalty. Paying more points is usually the better option because you only pay once, whereas refinancing the loan at a higher interest rate will cost you more money over the long term.
Reason for Prepayment Penalties
Lenders impose prepayment penalties as way to protect their investments. Small and subprime lenders, in particular, normally charge prepayment penalties. When you pay off a loan early, the lender makes less money in interest. The reason why you pay off the loan early doesn’t matter to the lender; all the lender cares about is that the bank isn’t going to make as much money.
Charging a prepayment penalty guarantees the lender a certain amount of the profit it expects to earn by making you the loan. You do have recourse if you realize that you were in too much of a hurry to sign the loan papers. The Truth in Lending Act gives you three days to change your mind about taking out a home equity loan. You must let the lender know in writing within three days of issuing you the loan that you want to cancel.
Home Equity Line of Credit
While not all home equity lines of credit and loans have prepayment penalties, many do. A home equity line of credit, or HELOC, is another type of home equity loan. Different from a traditional home equity loan, a HELOC doesn’t typically carry a prepayment penalty unless you close the account after you pay off the balance that you owe. If you leave the account open so that you can borrow against it again later on, the lender will not normally charge a prepayment penalty.
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