Penalty if a Mortgage is Paid Off Early

Is there a penalty if a mortgage is paid off early?

2 Answers

In certain situations there can be a penalty associated with paying off a mortgage early, there can also be penalties for paying off large portions of the mortgage (20% or greater) early; this will depend on whether or not you have a prepayment penalty. The actual definition of a prepayment penalty is: fees paid to the lender for the privilege of retiring a loan early. If you do not have a prepayment penalty associated with your current loan, you can pay off your loan at any time without incurring any additional fees or expenses.

If you do have a prepayment penalty, and the period of penalty is still in effect, then you may be subject to additional fees upon paying off the loan. It should be noted there are different types of prepayment penalties, hard and soft, and term lengths differ as well. You should review your loan paperwork and anything that speaks towards your prepayment penalty should you have one.

If you do elect to pay a prepayment penalty, often times this is tax deductable because it is considered interest paid. Make sure you bring this up with your tax preparer to see if it applies to you.   

This depends on the mortgage loan that you have. Each individual loan may or may not have a prepayment penalty (a penalty for paying the loan off early). If it does, there will be a clause written into the note that states that there is a penalty of X dollars if the loan is paid of within a certain period of time. You can check your loan by going through your closing documents and finding the note. Look for a section in the note pertaining to prepayment, or for a prepayment penalty rider that would be a separate document attached to your note. Finally, if you cannot locate the documents you can contact your lender and ask them directly if you have a penalty or not.

Prepayment penalties were most common on subprime loans, specifically the ARM's that were written in the earlier part of this decade. Penalties may also exist on various Alt-A loans, or jumbo loans. Typically conforming Fannie Mae and Freddie Mac loans, as well as government loans (FHA/VA) do not have prepayment penalties.

If a loan has a prepayment penalty, the way the penalty is structured can also vary. Often times they were written as a penalty of 1% of the principal loan balance (i.e - a $200,000 loan would have a $2,000 penalty if paid off early). In certain states penalties had to be structured as interest, so they may require 6 months of interest if the loan was paid off early. Lastly sometimes prepayment penalties were structured in a reducing amount, where, for example if you paid a loan off in year one you had to pay a 3% penalty, 2% in year 2, and 1% in the 3rd year of the loan.

Prepayment penalties also normally vary from being 2 years in length to 5 years. It is very unusual to see a prepayment penalty with a duration of more than 5 years.

Finally, the last variable on a prepayment penalty is whether it is a " soft prepay" or a " hard prepay". A soft prepayment penalty means that you are only required to pay the penalty if the loan is paid off via a refinance. No penalty is due if the loan is being paid off because you are selling the home. A hard prepay will require the penalty regardless of the reason for the loan being paid off.