Pre-payment penalties come in several different shapes and sizes. If you have a loan that has a pre-payment penalty, you should read your mortgage and it will tell you. Here's what to look for:

The first thing you want to know is the term of the pre-payment penalty. If you have a three-year pre-payment penalty clause, you may (more on that later) incur a penalty if you pay off the loan within the first three years.

The second thing you want to know is whether you have a "hard" or a "soft" pre-payment penalty. In the case of a "hard pre-pay" you will have to pay a penalty if you pay off the loan for any reason during the applicable period. On the other hand, in the case of a "soft pre-pay" the penalty only applies if you pay off the loan through a refinance. If you pay off the loan as a result of a sale, the pre-payment penalty will not apply. However, the lender will take steps to insure that the sale is an "arm's-length transaction" and not a sham sale to a relative or other cooperative party entered into for the purpose of avoiding the penalty.

The third thing you want to know is how the penalty is calculated. One formula is based on a percentage of the principal balance at the time of pre-payment. Thus, if the pre-payment penalty is 3% of the balance and the borrower owes $100,000 the time of pre-payment, the penalty would be $3,000. Another formula is a declining percentage. For instance, the pre-pay clause might provide that the penalty is 3% for pre-payment during the first year, 2% during the second year and 1% during the third year. The last formula is based on the calculation of the interest that would be paid on the balance (or some portion thereof) for a given period of time. The most commonly within this category is six months of interest on 80% of the balance at the time of pre-payment. Thus, if you have a $100,000 loan that carries an interest rate of 10% and you want to pay it off during the pre-payment penalty period, the penalty would be calculated as follows: 80% of the balance equals $80,000. One year of interest at 10% would be $8,000. Divide that by two to get six months of interest which equals $4,000.

To recap, if you have a loan with a pre-payment penalty clause, read it carefully to determine its terms. If you are getting a new loan, ask your loan officer for the terms and when you get to closing, be sure to review your documents to make sure the terms match up with what you were told. A pre-payment penalty isn't a bad thing in and of itself -- a lender might charge you a lower rate of interest in exchange for the assurance that you will either a) keep the loan for a give period of time or b) pay a penalty if you don't. The important thing is that you make an informed decision that reflects your financial priorities.

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To the home buyer, the mortgage is a loan that must be repaid. But to whoever fronted the money for them to get the home, that loan is an INVESTMENT.

Once that principle is understood, we can begin to talk about prepayment penalties as a method that investors use to protect their investment.

History has shown that when a borrower can qualify for a better rate, better terms, cash out, or other perceived benefit, they will refinance their loan in order to get it. If this happens quickly enough it can sabotage the investors portfolio of which their loan is a part. Prepayment penalties guarantee a minimum rate of return, thus making the investment more valuable to the lender. It isn't just something they do to make your life more difficult.

That said, the prepayment penalty has been very controversial recently. On conforming loans, there is no prepayment penalty. But many loans in recent history have not been conforming. These niche programs have utilized prepayment penalties in order to secure their investment and also to offer a lower interest rate than they otherwise could have.

The prepayment penalty takes a couple forms. A hard prepayment penalty will always be imposed if someone sells or refinances within the prepayment period. The amount is set by the lender's policies. It's common for the amount to be 6 months of interest on the loan, or a certain percentage of the loan such as 1% or 5% (on the high end).

A soft prepay is only enforced in the case of a refinance. Some prepay's are hybrid meaning they are hard for the first year and soft for the next two. Whatever the case, you should carefully examine the prepayment rider in your NOTE when you sign and make sure a neutral third party such as an escrow officer explains it to you. I would say on about half of the refinances I do, clients were not aware of the true nature of their prepayment penalty.

Get educated upfront to avoid pain later.

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A mortgage prepayment penalty is a penalty that a borrower will pay if they pay their loan off early. The earliness depends on a couple of different factors.

1. State law
2. Lender/Investor Guidelines

In some states a prepayment penalty may not even be allowed so you want to be sure what your state laws are before an agreement is entered in to which allows for a prepayment penalty. Most state laws that allow for prepayment penalties generally do not allow the penalty to exist for more than 3 years. The percentage of the penalty can vary significantly from state to state.

A prepayment penalty works when you enter into a loan which has a prepayment penalty provision (provision depends on state law and or Investor Guidelines). For example: If you have a prepay provision for 3 years and you decide to refinance your loan after 1 year the lender may enforce the remaining two year penalty. The fee is generally a percentage of your unpaid balance of your loan. Some states have language that allows for a lender to collect up to 6 months of prepaid interest. Most lenders do not allow the waiving of a prepayment.

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