How to use the Penalty in your Favor

The words Prepayment Penalty do not portray a positive set of circumstances. Prepayment Penalties can be attached to mortgages with many different circumstances. In most cases, a prepayment penalty is a fee charged to the borrower who pays off a loan before it is due or before the prepayment term expires. In addition, Payment Penalties may also be assessed when excessive portions of the loan’s principal balance (generally 20% or more) are paid down in a single year. Some Prepayment Penalties are only incurred when a loan is refinanced (known as soft prepayments), but other penalties may be incurred if the loan is refinanced, the property is sold or excessive principal balance reductions are made (know as hard prepayments). In this brief narrative, we have already seen how complex and intricate these prepayments penalties can be. When you are dealing with a financial penalty such as this, your options should be fully discussed with a Mortgage Professional.

To help clarify this financial pitfall with an example, let’s suppose you have a $200,000 loan with a 3 year hard Prepayment Penalty. This penalty will be incurred if the property is sold, refinanced, or the principal balance is paid down by more than 20% per year for the first 3 years of the loan. The 3 Year Prepayment Penalty could be structured as 3% of the principal balance due at time of infraction. That would mean $6,000.00 (based off of the $200,000 Loan Amount) due to the lender, or holder of the note, at the time of infraction.

This penalty is not something with which you want to gamble. However, there are circumstances in which a prepayment penalty might not be such a financial risk, and it may ultimately be used as a wise financial decision. Let’s suppose you are purchasing your “dream home” with a 30 year fixed rate mortgage, or that you are buying a second home in which you plan on retiring, or if you buy a starter home with a 10 Year ARM because a 5 year ARM is just not long enough. For any of these circumstances, wouldn’t you be interested in lowering your interest rate by possibly .25%, if not more? By attaching a prepayment penalty to your loan, the interest rate can be reduced. For the right set of circumstances, a 2, 3 or 5 year Prepayment Penalty may not be such a high risk. In addition, this quarter point + reduced interest rate would mean significant monthly savings, adding up to tens of thousands of dollars over the life of a 30 year loan. Prepayment Penalties should be fully analyzed with a Mortgage Professional to determine if the risks are minimal enough to make the penalty financially beneficial.

William DesPortes
DesPortes, Selig & Associates
Professional Mortgage Services
Managing Member
970-949-0653
wdesportes@qwest.net

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