A penalty for paying off your mortgage early sounds insane, right? What bank wouldn’t want you to pay your mortgage off early? They get their money early, and you aren’t a risk of default for them any longer.
There’s a reason.
It’s called interest. Banks are in the business to make money. So when you pay your mortgage off early, you eat into that interest. In other words, you cost the bank money if you pay your mortgage off early.
Fortunately, there are ways around the prepayment penalty. Plus, not every mortgage has one, especially since the Dodd Frank Act changed things.
What is a Prepayment Penalty?
A prepayment penalty is a charge some lenders require if you pay your mortgage off before a specific date. They don’t go through the end of your term. Most penalties are for the first three years of your loan, but every lender is different.
The prepayment penalty prevents borrowers from paying off all or a large part of their mortgage. Lenders would prefer you pay the loan back slowly and steadily because this accrues more interest, aka profit for the bank.
If you decide to pay your mortgage off early, you’ll pay the bank a lump sum of interest. This is the interest they would have earned if you didn’t pay it off early.
Can Lenders Charge a Prepayment Penalty?
The Dodd Frank Act of 2010, the new mortgage regulation guidelines, makes it more difficult for lenders to charge prepayment penalties. Lenders that charge prepayment penalties cannot make them for more than three years. Lenders cannot charge more than 2% in the first two years and more than 1% in year 3.
Why Lenders Charge a Prepayment Penalty
Banks want to make money. It’s how they can stay in the business of loaning money to buy homes.
But what’s the difference if you pay your loan off in 2 years versus making regular payments?
Lenders take a significant risk when you first borrow money. Let’s say you put down 5% on a $300,000 home. The bank lends you $285,000, and you invest just $15,000. The bank is on the losing end of this deal, right?
Normally, they’d need to charge a hefty interest rate to compensate for this risk. What if you stop making payments after just six months? You’ll have barely touched the principal at this point, which leaves the bank with a major loss.
With a prepayment penalty, they can give you a much more affordable interest rate and ensure they still make money on the loan. If you paid the loan off early, you’d have to pay a penalty for the interest they’d lose.
Does Every Payment Incur a Penalty To Pay Off Your Mortgage Early?
You’re probably wondering at this point, does every payment incur a penalty to pay off your mortgage early?
In other words, if you pay an extra $200 toward your principal for a couple of months, will you pay a prepayment penalty?
Fortunately, the answer is typically ‘no.’
Most lenders allow you to pay as much as 20% extra periodically without penalty. They aren’t worried if you pay a few extra hundred dollars toward your principal. While it knocks your principal balance down a little faster, it only reduces your term by a couple of years.
Lenders lose the most when you refinance after a year or two or sell the home right away. This is when the prepayment penalties are the most prevalent.
How Much Do Lenders Charge for a Prepayment Penalty?
Like interest rates and closing costs, lenders charge different amounts for the prepayment penalty. Here are some of the models they might follow.
Pay a Certain Number of Months in Interest
Lenders may choose a certain number of months of interest they want you to pay if you pay the loan off early. For example, they might charge 12 months of interest if you pay your loan off in the first year, six months if you pay it off in the 2nd year, and three months if you pay it off in the 3rd year.
Pay a Percentage of the Loan Amount
Lenders may also choose to charge you a percentage of your loan amount if you pay the loan off early. For example, they may charge 2 – 3% of the loan amount if you pay it off within the specified time.
How to Find Out if your Mortgage Has a Prepayment Penalty
The easiest way to tell if your mortgage has a prepayment penalty is to look on Page 1 of the Loan Estimate.
Every lender must send you a Loan Estimate within three business days of applying for the loan. On Page 1, you’ll see a section that states ‘prepayment penalty’ and then ‘yes’ or ‘no.’
If it’s ‘yes,’ it will also state how much you’ll pay if you pay the loan off early.
Does It Make Sense To Pay Off Your Mortgage Early?
The bigger question is if there is a penalty for paying off your mortgage early, does it make sense to do so?
Consider these questions.
Can You Get a Better Return on Your Investment Elsewhere?
Before paying off your mortgage early, consider where else you could invest the funds. Depending on your time horizon for investing, you might find that you make more investing in your home than other investment options.
Do the math and the research to be sure, though. Don’t just assume your money is best spent on your mortgage. Make sure of it because once you pay your mortgage off, there’s no turning back unless you sell the home.
Do You Have an Emergency Fund?
When you pay your mortgage off early, you tie up your money in the home. You can’t easily liquidate it because you have to sell the home. This could take months or longer, depending on the market.
If you don’t have an emergency fund for 3 to 6 months of expenses, don’t pay your mortgage off early.
You may want to have even more money saved, though. Do you have enough to save, give, invest, vacation, or do other things you care about? Tying up all your money in your home may not be all it’s cracked up to be if you can’t do what you want with your money.
Will You Feel More at Peace Paying Off Your Mortgage?
Some people hate debts hanging over their heads. If you lose sleep at night thinking about the interest you pay on your mortgage, you might feel better paying it off.
On the flip side, having your money tied up in your home might bug you more rather than paying it off slowly.
Think about what you value the most and handle your mortgage that way. If paying it off in one lump sum worries you, consider other options, such as bi-weekly payments.
Steps To Take To Pay Off Your Mortgage Early
If you’ve decided the penalty for paying your mortgage off early is worth it, or your mortgage doesn’t have a prepayment penalty, here are the steps to take.
Make Sure You Have an Emergency Fund
Before tying your money up in your home, make sure you have money set aside. For example, emergency funds cover your expenses in extreme circumstances when you can’t work. Also, consider having money set aside for home repairs, car repairs, and medical emergencies.
Don’t just ‘get by,’ have enough money set aside to get you through any situation without a financial struggle before paying off your loan.
Max Out Your Retirement Accounts
Don’t ignore the need to save for retirement. If you haven’t saved, do that before paying off your mortgage. If you’ve already started retirement accounts, max out how much you contribute. The more you contribute early on, the more time it has to grow and support you during retirement.
Related Content: Coast FIRE: How Our Family Saved $500k by 40 Years Old
Pay off High-Interest Debt
If you have high-interest debt, pay it off before paying off your mortgage. Consumer debt interest rates are much higher than the interest you’ll save paying off your mortgage. Don’t carry high-interest debt in exchange for paying off your mortgage early. You’ll waste more money doing it that way.
If you decide all the stars align and you want to pay off your mortgage, make sure you take these essential steps to ensure it’s paid off correctly.
Final Thoughts on A Penalty for Paying Off Your Mortgage Early
Paying off your mortgage might seem like the holy grail of personal finance. You can proudly say you own your home free and clear.
There are bragging rights in paying off your mortgage early but watch for the penalty for paying off your mortgage early. Admittedly, they aren’t as common as they used to be before the housing crisis, but they do exist.
Even if you don’t have a penalty for paying off your mortgage early, though, it doesn’t always make financial sense. Evaluate your financial situation and ensure you’re in a position to tie up your money in your home, remembering it could be a long time before you can access the funds should you have an emergency.
What about your situation? Is there a penalty for paying off your mortgage early?
Please let us know in the comments below.