Prepayment Penalty

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Mortgage Dictionary -> Prepayment Penalty

There are, unfortunately, a lot of hidden costs when it comes to loans particularly mortgages. One you may not notice until it's too late is the prepayment penalty. That's because many lenders do not make it crystal clear that you are subject to this penalty should you do something to incur it. In this article, you'll learn all about the prepayment penalty: what it is, why it's used and how to avoid it.

What is the Prepayment Penalty?

If you've ever held a Certificate of Deposit and have turned in it early, then the idea of a prepayment penalty won't seem foreign to you. When you turn in a CD, you are hit with a premature withdrawal penalty, and when you pay off your mortgage either with your own cash or with another lender's money before a certain time in the loan, you're subject to a penalty from the original lender. This penalty is the prepayment penalty, and it can be quite expensive, sometimes costing upwards of several thousand dollars.

Why Do Lenders Use It?

For the most part, lenders only use it with borrowers who have blemished credit records. The prepayment penalty serves as a way of backing the lender's investment and making sure that no matter what, they get their money's worth out of the transaction with you. Lenders know that those with blemished credit records are more likely to refinance within a couple years of getting the mortgage just to save money or to pay off other debt. Because this can cost the original lender a lot of money, the lender applies the prepayment penalty as both as way of protecting themselves and discouraging paying off the loan. Usually, this penalty applies only within the first 5 years of the mortgage.

How Can I Avoid It?

Unfortunately, there's not a whole lot you can do to avoid the prepayment penalty, except to try to prevent it from being put into your mortgage contract. While many lenders will not allow this, some will, particularly if your credit warrants it.

You can also avoid the prepayment penalty by simply waiting until the penalty has expired to refinance or buy the home outright.