Prepayment penalties sound like a terrible word and a waste of money. Yes and no. No? What do you mean no. There are many different types of prepayment penalties on mortgages and many reasons why this takes place. You need to start with a knowledgeable loan officer that will explain this to you.
Why are there prepayment penalties on some loans? It's usually because you either have bad credit which would put you into the subprime market or because you can't prove your income (Alt-A loans) and are placed into some sort of stated program. Why does this matter to you? Generally people should improve their credit situation and credit scores over time. Or if they can show their income, they might be able to do this in a few years or build more equity in 2 to 4 years which will allow them to refinance into a lower rate.
Since you might improve over time, there is a good chance that you would be able to refinance in a shorter period. This is not always the case, depending on the market, such as housing values. But the lender is risking their money to make some sort of profit in a certain time frame. Generally they would need to hold onto your loan for 8 to 10 years for this to happen, making money on your interest. Considering that is a long time, this is the reason for prepayment penalties on these types of mortgages. It comes down to the risk factor and the risk the investor took in the beginning to lend you money.
Let's explore which loans might have a a prepayment penalty. Keep in mind, every state is different. Some states allow for prepayment penalties and some don't allow for this.
What loans don't have these prepayment penalties :
- FHA, Conventional (FNMA/FHLMC), and VA loans
- Some Alt-A programs (sometimes built into the rate)
What loans do have prepayment penalties :
- Some Alt-A programs
- Subprime loans in those states that this is allowed in. If not, the prepayment will be built into the rate.
Your typical prepayment penalty is usually 6 months of interest of the remaining principal balance. For a quick estimate, you can just multiply your monthly payment by 5. For a more accurate account of your penalty, multiply your interest rate to your balance of the mortgage. Then take that number and divide it by 365. This will give you your daily interest. Then multiply this number by 30 days. This is your interest for 1 month. Then multiply it by 6 and this will give you your penalty for a 6 month period.
Example :
$320,000 balance x 8.00% interest rate = 25,600 Then 25,600 divided by 365 = $70.14
Then multiply $70.14 by 30 days = $2,104.20 per month Then multiply this by 6 = $12,625.20
$12,625.20 is your penalty. It's up to the loan officer to give you your options. In most cases, there are options, but sometimes the lender can't make YSP (yield spread premium) on your rate if you don't choose a prepayment penalty. That means all of the money that they make on you has to be in regards to upfront points and fees.
Prepayment terms to pay attention to :
- Hard prepay : Typically for 2 yrs, 3 yrs, or 5 yrs. This means that you can't sell your house or refinance during these terms. If you do, then there is a prepayment, usually 6 months interest. Some states vary.
- Soft prepay : This means that you can't refinance, but if you sell your home during this time, there won't be any type of prepayment penalty. These are usually the same length of time as a hard pay penalty.
Conclusion on what's better : It all comes down to exploring your options, knowing your goals, and to see whether or not which option might make sense for you. And the other type of penalty could be 2% of your principal balance. Depending on the lender and the state. Speak to a trusted Mortgage Consultant who can explain this too you and not just say "because".
Just a side note, I was inspired to write this after a comment that Missy Caulk left me in this post, Mortgage Rates -- Locking or Floating -- Part 2 of 2
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