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Mortgage Prepayment Penalty

A Mortgage Prepayment Penalty is often "required" by both lenders and brokers who originate several types of mortgages and are often not disclosed at application or are very poorly disclosed while the loan is in process. A mortgage prepayment penalty is most often seen in the subprime market, investment property financing and Option Arms. I have heard entirely too many stories about people getting to closing only to discover their loan has a mortgage prepayment penalty when it is too late to do anything about it. As a broker who does a lot of these loans with no, or only a short term, mortgage prepayment penalty, I want to make sure you know what they are and how to minimize their impact.

A mortgage prepayment penalty is assessed and added to your loan balance when your loan is paid off in full or if your loan balance is reduced by 20% or more in one year. There are two types of prepayment penalties in use today. First, is what is described as a "hard" prepayment penalty which is assessed if the loan is refinanced or the property is sold. Second, is described as a "soft" prepayment penalty and is assessed only when the loan is refinanced or the loan balance is reduced by more than 20%. If the property is sold, a mortgage prepayment penalty is not assessed.

Now, for the really bad news. While there are a very few states that control the amount a lender can charge for a mortgage prepayment penalty most lenders will charge you a whopping 3% of your loan balance when the loan is paid off prior to the expiration of the penalty period! For example, a $400,000 loan could cost $12,000 just in penalties to get out of. If you have the typical 3 year prepayment period, you are trapped until the prepayment period expires.

Why do lenders and brokers do this? In a nutshell, money. Lenders, in their defense, incur significant costs to create a mortgage and are counting on holding the loan for a period of time to recoup their cost. If you pay off early, they lose money. To give you an idea of the magnitude of the problem, quite a few years ago, I managed a "brick and mortar" mortgage operation. I took a very hard look at our costs and found that our fixed costs for every loan we originated was nearly $5,000 and that we had to hold the loan 2.25 years just to break even. To be fair, cost structures are better today but you can see the issue. Brokers are typically compensated by the lender for originating a loan and the broker's compensation is frequently tied to the length of the prepay period. For example, an Option Arm without a prepayment period will net the broker little or no compensation (a tough way to stay in business) while one with a 3 year prepayment penalty will get the broker up to 3.5% of the loan amount in compensation.

How do you protect yourself? It is not good enough with these types of loan simply to ask for a Good Faith Estimate before you agree to the loan. The Good Faith does NOT disclose a mortgage prepayment penalty. Ask for a Truth in Lending statement and please, please talk to any loan originator about the mortgage prepayment penalty before you decide. You need to know the length and amount before you can make an informed decision.

I hope this helps you to understand the ramifications of a Mortgage Prepayment Penalty.

For the the greatest flexibility and maximum loan qualifying ratios, you may be interested in the Cash Flow ARM with no or a short mortgage prepayment penalty

As a Certified Mortgage Planning Specialist, I offer an analysis of your situation today can make suggestions on how small changes in how your consumer and mortgage debt is structured today can have a life changing effect in the years to come.  Read more about this free, no obligation service.

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