Getting a mortgage loan these days means making more decision than ever before. One of those decisions concerns the pre-payment penalty. The “penalty” in the title makes this loan term seem like a punishment to be avoided. Used correctly, however, a pre-payment penalty on a mortgage loan can be a painless way to reduce your interest rate over the life of the loan. I have benefited from pre-payment penalties on several of my own personal loans.
The provisions of a pre-payment penalty are tricky. The key is for the borrower to understand fully what his or her options are and to make an informed decision.
Basically, a pre-payment is a promise by the borrower to
keep the loan for a certain amount of time, usually two or three years. Lenders
appreciate the certainty that they will collect payments for a while so in
return they give something back to the borrower. What they give back is a lower
interest rate for the life of the loan.
A pre-payment penalty is not available on some loans. It is mandatory on other
loans - usually when the borrower has poor credit.
In the ideal situation, the borrower accepts a pre-payment penalty for two years. In return for this promise to provide steady payments, the lender lowers the interest rate by about one-quarter of a point. The borrower makes the payments for all 24 months. At that time, the promises of the pre-payment penalty are fulfilled. The borrower is now able to refinance or pay off the loan (at the time of sale) with no penalty.
The first thing a borrower must understand is the
consequence of not fulfilling the promise to pay for the entire penalty period.
If the borrower pays off the loan during the pre-payment period, the penalty is
substantial. Many formulas are used to determine the penalty. A common one makes
the penalty equal to about six months of payments. Multiply your monthly
mortgage payment by six and you will feel the pain.
So if you are considering using the pre-payment penalty, you must be reasonably
certain your finances are stable enough so that you will not have to sell or
refinance your house. Consider not only your current financial situation but
also the likelihood of poor health, job transfer, family emergency or whatever
else may happen in the normal course of life.
Generally speaking, the pre-payment penalty is stiff
enough so that if you think there is a chance you will have to pay off the
mortgage early, it's best not to take the chance on the pre-payment penalty
clause.
Once you understand the basic idea of a pre-payment penalty, you will want to
look into variations. Sometimes the penalty only applies if you refinance the
house but not if you sell it. Or the penalty amount might be high in the first
year and decease in subsequent years.
The successful borrower is an informed borrower. During the loan application process, you may feel overwhelmed by paperwork. But each of the documents is important. One of them will be the Truth in Lending Statement, which every home loan borrower must receive after making the application but before committing to close the loan. Your Truth in Lending Statement will say whether or not you have a pre-payment penalty.
You may still feel like asking your mortgage professional for the precise details of your pre-payment penalty. Do so. The intricacies of the penalty stump most people. Even professionals have to double check.
A pre-payment penalty is neither good nor bad all by
itself. It's a matter of whether the exact pre-payment penalty in your loan fits
your situation today.
Only enter into the mortgage contract with the confidence that you understand
all options available to you regarding pre-payment penalties.