What is Prepayment Penalty in Mortgage?

In many of the mortgage contracts made between the parties, many times there is a prepayment clause that states that if payment is made in advance by the borrower before the due date of payment, then it shall treat that the terms and conditions of the contract are not adhered to by the borrower. Hence, would be liable to pay the penalty known as the prepayment penalty.

Explanation

When one party of the contract pays the other party sum of any debt before its due date, it is known as prepaymentPrepaymentPrepayment refers to paying off an expense or debt obligation before the due date. Often, companies make advance payments for expenses as well as goods and services to shed their financial burden. Advance payments also act as a tool to attain monetary benefits. Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.read more. Now, if the borrower makes the prepayment of the loan, then it would be liable to pay the penalty for the same as mentioned in the contract created by the parties at the beginning of the deal.

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How Does it Work?

There is prepayment riskPrepayment RiskPrepayment Risks refers to the risk of losing all the interest payments due on a mortgage loan or fixed income security due to early repayment of principal by the Borrower. This Risk is most relevant in Mortgage Borrowing which is normally obtained for longer periods of 15-30 years.read more in the mortgage contracts wherein the borrower pays an amount in advance from its due date. Then, the lender might lose his business. So, it is generally specified in the mortgage contract mentioning the details about the prepayment penalty calculation in case of the prepayment. The terms and conditions of the clause are to be mentioned by the lender well in advance when completing the deal of such a loan.

Types

There are mainly two types associated with the prepayment of the amount due. It includes the following: –

  • Hard Penalties – These prepayment penalties are levied on the borrower if payment is made in advance from the home sale and the refinancing RefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more.Soft Penalties – These prepayment penalties are levied on the borrower if payment is made before refinancing. Thus, if the borrower pays in advance after selling his home, he would not be liable for the penalty.

Example of Prepayment Penalty in Mortgage

Mr. Tom took the home loan ten years back from the bank named ABC Bank Ltd. for 20 years. The current outstanding balance of the loan is $1,000,000. When making the contract, they decided that he would pay 3% of the balance amount as the prepayment penalty if the borrower completes the loan prepayment. So, if the borrower wants to repay the loan, what will be his penalty?

In this case, it is levied based on the percentage of the loan balance, which is 3%, as mentioned in the contract.

  • = $1,000,000 * 3% = $30,000

How is it Calculated?

Different ways are used in which the lender can calculate the penalty by mentioning the contract terms. It includes the following: –

  • A Flat Amount of Penalty: Under this, a flat amount is mentioned in the contract, which the borrower must pay in case of the early payment of dues.Based on Percentage of Balance of Loan: The loan prepayment penalty is sometimes calculated based on the loan’s remaining balance percentage.Cost of Interest: This can be levied based on a certain amount of the month’s interest per the contract condition.

Why Do They Exist?

When the borrower makes the payment before the due date of the payment of the loan amount, then there are chances that the lender of the money might lose its business. That is so because the lender, in case of the prepayment, will lose the interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more, which otherwise he will get if the borrower makes the repayment on the due date.

So, to protect the lender’s interest and provide compensation against such loss, a prepayment penalty clause is entered in the contract between the lender and borrower where it will be levied on the borrower if he makes the payment in advance from the date when it becomes due. It usually varies from lender to lender as per the terms and conditions of the contract.

How Much Does Penalty Prepayment Cost?

Prepayment penalty costs are based on the terms and conditions mentioned in the contract executed by the lender and borrower at the beginning of the contract. It can be calculated based on the percentage of the balance of a loan or based on a certain number of the month’s interest, or it can be a flat amount.

How to Avoid Prepayment Penalties in Mortgage?

If the person wants to avoid the prepayment penalties, one should look for a lender who does not charge the penalty in case of the loan prepayment; however, if the contract is already executed with the penalty clause. The borrower should look at the terms and conditions and check if it can save the penalty by making partial payments because some lenders do not charge prepayment penalties in case of partial repayment.Also, one can avoid the prepayment penalties by selling the asset in case of the soft prepayment penalties instead of refinancing the same.

Conclusion

Generally, there are two types of prepayment penalties: hard prepayment penalties levied if the borrower makes payment in advance from either sale of the home or the refinancing, and soft prepayment penalties set if the borrower makes payment in advance from the refinancing.

This article is a guide to the Prepayment Penalty and its definition. Here, we discuss the formula to calculate, prepayment penalty example, and its types. You can learn more about accounting from the following articles: –

  • What is Loan Syndication?Short Sale vs ForeclosureMortgage CalculatorAmortization Schedule for a MortgageCross Collateralization