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A mortgage prepayment penalty is a fee you pay the lender if you sell, refinance, or pay off your mortgage within a certain amount of time of closing on your initial mortgage — usually three to five years.
You probably won't have to pay a penalty if you pay extra toward your mortgage every month, or if you make supplemental payments here and there. It will likely only be if you either a) pay off the mortgage completely by making a large payment, selling, or refinancing, or b) pay off a huge portion of your mortgage all at once.
The terms of your prepayment penalty will be included in the documents you sign at closing, but your lender should inform you about penalties well before then. If a lender provides a mortgage that includes prepayment penalties, it is also legally required to offer you an alternative mortgage that doesn't charge penalties. If you're already in the homebuying process and your lender hasn't brought up the subject yet, don't be afraid to ask.
Some mortgages impose hard penalties and others have soft penalties.
With a hard penalty, you'll pay a fee if you sell or refinance your home. But with a soft penalty, you'll only pay if you refinance — you can sell at no extra cost. Again, the details about whether you have a hard or soft penalty should be spelled out in your closing documents.
Legally, lenders can't charge prepayment penalties on certain types of mortgages. You won't pay a penalty on most government-backed mortgages, including VA, USDA, and single-family FHA mortgages.
You might have a prepayment penalty on a conventional mortgage, but remember that your lender is legally required to offer you an alternative without a prepayment penalty.
Each lender has its own methods for charging mortgage prepayment penalties. Here are some possibilities:
Talk to your lender or refer to your closing documents to learn all the details of your prepayment penalty.
If you pay off your mortgage super early, like within a few years of taking out your loan, the lender misses out on up to tens of thousands of dollars you would have paid in interest over the years.
If you refinance, you could go through a different lender. If you sell, there's a good chance the buyer will use a different lender. Regardless, your current lender would miss out on money.
A prepayment penalty may discourage you from paying off your mortgage early, so the lender gets to keep your business. If you do pay off the loan early, the lender at least offsets that loss by a little bit.
Depending on your situation, you may decide that incurring a prepayment penalty is worth it. For example, if you pay a $500 flat fee for paying off your mortgage early but save $10,000 in interest, you may still choose to go for it.
