Perhaps you’re selling your home or thinking of refinancing now that the interest rates are so low, do you know if your current mortgage has a prepayment penalty clause?

While prepayment penalties are not as common as they once were, depending upon when you took out your current mortgage, your bank or mortgage company may have given you this option when you completed your paperwork.

A prepayment penalty is a provision in your mortgage that states you will pay a fee, or penalty, to the lender in the event that you pay off the loan, or a portion of it, before a specified time period (for example, less than 5 years) or the end of the loan term.

Typically, the penalty is a percentage of the outstanding principal balance at the time of prepayment. For example, if the penalty is 3% of the balance, and you owe $100,000 at the time of prepayment, the fee would be $3,000. However, another prepayment formula uses a declining percentage that may call for a 3% penalty during the first year, a 2% penalty during the second year, and a 1% penalty during the third year. This calculation is based upon the amount of interest that would be paid on the balance during a specific time period – for example, 6 months of interest on 80% of the balance at the time of prepayment. In this scenario, if you have a $100,000 loan that has a 10% interest rate that you want to prepay, the penalty is determined as:

• 80% of the balance equals $80,000.
• One year of interest at 10% is $8,000.
• $8,000 divided by 2 (to get 6 months of interest) equals $4,000.

Reasons you may prepay your mortgage include when you:

• Refinance your mortgage for a lower interest rate, and your current loan is paid in full, so the new mortgage loan can be issued.
• Make a payment against the mortgage’s principal.
• Sell your house and the loan is paid off.

Generally, most lenders only require you to pay a prepayment fee if you pay back the loan early, such as during the first 3 to 5 years of taking out the loan, and they don’t require a fee when you sell your home. A prepayment due to refinancing is considered a “soft” penalty.

A “hard” penalty is when you have to pay a fee regardless of the reason for paying off the loan. However, with most loans, you can make partial prepayments of up to 20% of the loan balance within any one year without paying a fee.

Prepayment penalties are not necessarily a bad thing. In exchange for accepting the prepayment penalty clause in your mortgage, you may receive a lower interest rate and/or lower closing costs. While your lender has the assurance that you’ll keep the loan for a specific time period or you’ll pay the fee.

To determine if your current mortgage has a prepayment penalty, you should carefully review your mortgage paperwork. You should look for the words “prepayment penalty terms” or a “prepayment penalty rider.”

If you have any questions regarding an existing prepayment penalty clause or the terms on your new mortgage, contact your mortgage broker for answers, so you can make an informed decision.