What Are Pre-Payment Penalties?

A pre-payment penalty is a penalty charged if the mortgage loan is paid off in its entirety earlier than the specified term of the loan. Pre-payment penalties are calculated as a percentage of the outstanding balance at the time the loan is paid off or as a certain number of months of interest and usually disappear over time.

Pre-payment penalties apply to home sales as well as refinance transactions. For home sales, a pre-payment penalty is sometimes referred to as a "hard" penalty. For refinances, it is sometimes referred to as a "soft" penalty.

If you are a subprime borrower, or a borrower with less-than-perfect credit, a pre-payment penalty may be required because of the fact that subprime borrowers carry a higher risk to the lender. But even so, if you're a subprime borrower, you may be able to negotiate the terms of the pre-payment penalty.

The benefit to lenders charging a pre-payment penalty is not only to protect them from risk, but also discourages the borrower from refinancing should rates drop in the future.

However, prime borrowers, or borrowers with good credit who make a large enough down payment, usually can get a better interest rate if they accept a pre-payment penalty. If you are a prime borrower, ask your mortgage banker about accepting a pre-payment penalty in exchange for a lower interest rate.

Some lenders, such as Quicken Loans, do not charge any pre-payment penalties. Also, depending on the type of loan program and whether or not your state allows them, pre-payment penalties may or may not even be charged.

Be sure you ask your mortgage lender lots of questions before closing. Make sure you know exactly what fees you will have to pay upon closing as well as any other charges that may be incurred, such as pre-payment penalties. Then at the day of closing, don't just sign the loan documents without reviewing them carefully. Be sure you read each page carefully and are aware of all the terms of your contract.