What You Should Know About Mortgage Prepayment Penalties

Purchasing a real estate property through a mortgage is a substantial financial commitment and thus, the underlying terms and conditions should not be ignored. The property buying process includes contractual agreements that may indicate mortgage prepayment penalties. To share what I know from my role as CEO of a company based in the mortgage and financial industry, I’ve compiled my experience to better inform you on this aspect of mortgages.

What Is A Mortgage Prepayment Penalty?

When you buy a property with a loan from the bank or any other financial institution, the lender may impose a contractual clause that prevents you from paying off your mortgage earlier or faster. If you increase your mortgage payment or make a lump-sum prepayment outside of the agreement in your mortgage contract, you will be subject to a mortgage prepayment penalty.

Some types of mortgages have prepayment penalties, while others are more flexible. The type of mortgage you get from a lender can determine whether you will need to pay prepayment fees if you decide to make lump-sum payments, increase your mortgage payments or refinance your mortgage.

The Cost Of Mortgage Prepayment Penalties

Prepayment penalties and calculations for the actual prepayment cost vary across lenders. The prepayment penalty cost usually depends on the prepayment amount, interest rates and the remaining term of your mortgage. Generally, the prepayment penalty may be calculated as the interest rate payments for a specified number of months or an interest rate differential (IRD) — the difference between your current mortgage rate and the ongoing market rate.

The prepayment penalty for fixed rate closed mortgages can be either of or the greater of your three months’ interest payments and an interest rate differential (IRD).

The prepayment penalty for variable rate closed mortgages will be your three months’ interest payments.

If you get a fixed mortgage from one of the big banks, chances are you’ll be charged with higher prepayment fees than a monoline mortgage lender. Monoline mortgage lenders are generally more lenient with prepayment penalties. Getting out of a fixed mortgage with a big bank can cost a large sum in prepayment charges using the interest rate differential method simply because banks calculate the penalty based on the spread of your contract rate and the posted rate. Most monoline lenders give a relatively fair penalty because they calculate the penalty based on the spread of your contract rate and the going discounted rate for that product. If you need to break a fixed mortgage with a monoline mortgage lender, you’ll approximately pay one-third of what the big banks charge in prepayment penalty fees.

The Type Of Mortgage You Get Can Impact The Prepayment Fees Charged

The different types of mortgages can determine if you will pay a prepayment penalty when you increase your payments or break your mortgage contract. The type of mortgage you get can also determine how much your prepayment penalty cost will be, based on interest rates.

For example, if you have an open mortgage, you will have some flexibility in terms of loan payback terms. With an open mortgage, there are usually no contractual limitations on when you can pay off your mortgage or exit the mortgage contract. You can also pay a lump-sum amount to reduce your principal at any time without any penalties. Because of this prepayment flexibility, the interest rates on open mortgages are relatively higher compared to closed mortgages.

On the other hand, if your real estate property is purchased with a closed mortgage, this usually requires you to remain with your lender for a specified period before you can change the terms of the mortgage or refinance your mortgage for a better interest rate or borrowing terms. With a closed mortgage, you are generally not able to pay off your mortgage before the specified term in your contract; if you do, you may be subject to penalties. Closed mortgages usually have lower interest rates than open mortgages to compensate for the lack of prepayment and refinancing flexibility.

Prepayment penalties for closed mortgages as noted above are usually the higher of your three months’ interest payments and the calculated interest rate differential (IRD).

Mortgage Prepayment Privilege

Some mortgage lenders may allow you to increase your mortgage payments but within a specified limit, after which a prepayment penalty will apply. Also, some lenders do not permit lump-sum payments toward your principal, while others may give you the flexibility to pay a lump-sum amount up to a certain percentage.

When a mortgage lender allows you to increase your mortgage payments or pay lump-sum amounts toward your mortgage principal, this is usually known as a mortgage prepayment privilege. Prepayment privileges vary across lenders and can be in the form of an allowable amount or a specified percentage based on the original mortgage amount per year. The prepayment privilege limits are typically applied to a current year and cannot be accumulated or carried forward.

For example, if you have an original mortgage cost of $500,000 and your lender allows you to make lump-sum payments up to 15% of your original mortgage per year, this would mean that you may be able to make a total lump-sum payment of $75,000 per year. If you make a cumulative lump-sum payment of $80,000, you will be subject to a prepayment penalty fee.

Conclusion

Before you get into a mortgage contract, it is important to review any prepayment penalty clauses, the mortgage rates and terms. Ensure that your mortgage lender provides enough flexibility to enable you to meet your needs now, and in the future.

Mortgage prepayments can be very costly. To avoid these charges, it is important to find a lender that is more flexible with their mortgage terms and conditions. Monoline lenders are usually less stringent with their mortgage terms on fixed-rate mortgages, and as such, they may offer more flexibility to borrowers in terms of prepayments. 

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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