How Prepayment Penalties Increase the Cost of Borrowing
A prepayment penalty refers to a clause in a loan or mortgage agreement, stating that a penalty will be assessed for early payment. Financial institutions perceive this as risky. They lose money when a loan is paid off earlier than specified in the agreement. Borrowers choose to pay off their outstanding balance early to save on interest payments.
The clause can state that borrowers owe several months of interest or a percentage of the mortgage balance. In many cases, no penalty is assessed after 5 or more years of payment. Financial institutions also allow a partial prepayment of 20 percent of the outstanding balance.
People with poor credit often resort to refinancing at some point. They may refinance when they rebuild credit, which is risky for creditors. Financial institutions assess penalties for refinancing and sale of real estate properties. Borrowers who refinance and sell their home incur a hard penalty. Those who choose to refinance only are assessed a soft penalty. Refinancing saves a lot of money in interest charges. However, paying 3 or 4 percent of the outstanding balance to terminate the contractual relationship makes refinancing an expensive option.
Check What Your Lender Offers
In some cases, financial institutions offer mortgages with terms that are disadvantageous to the borrower. This is the case with a 5 percent prepayment penalty and 11 percent in interest charges. Banks don’t have an incentive to waive or reduce the penalty, especially if the client wants to refinance with another lender. They may modify the terms and rewrite the note in some cases, for example, a community group intervening on the borrower’s behalf.
Some financial establishments offer a declining penalty. It can be 3 percent during the first 1 or 2 years and 2 percent afterwards. Calculating the amount owed is not difficult. Borrowers are usually allowed to prepay 20 percent of the balance a year. Thus a penalty will be assessed on 80 percent of the mortgage balance. If the borrower pays an interest rate of 7.5 percent on a $425,000 loan, the interest charges amount to $2656.25 a month. Multiplying this by 6 months gives $15,937.5. Then take 80 percent of this amount, and your prepayment penalty is $12,750. In this example, you should plug numbers for the remaining balance and the allowable prepayment.
Mortgages with a prepayment penalty are a costly way to borrow, especially if you decide to refinance. Otherwise, borrowers benefit from a lower rate of interest. Some financial institutions offer loans with no penalty for early payment and then insert this clause. Don’t let this happen. If a financial institution sells a mortgage in the secondary market, the loan is worth 1 percent less without a prepayment penalty. Thus banks profit from loans with such clauses. What a borrower can do is negotiate with the lender before signing the agreement. Ask the officer whether the penalty can be waved in case you sell the house. This provision should be incorporated in the agreement.
Read the papers to avoid a hefty penalty. The wording you should be looking for is prepayment disclosure. Check the fine print as well and if you spot such a clause, contact a manager or loan officer. Managers are the ones with decision-making power. Ask whether the percentage can be reduced. Some financial institutions assess penalties for 1, 2, 5 and even 10 years. You can ask whether they can reduce the percentage even if you haven’t reached the threshold yet. If you have an excellent credit, you may want to take a mortgage with no prepayment clause.
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