Tutorial on Whether to Accept a Prepayment Penalty

18 April 2006, Revised November 18, 2008

A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Prepayment penalties usually decline or disappear with the passage of time, seldom applying after the fifth year. For additional details, see Mortgage Prepayment Penalties.

Most borrowers in the sub-prime market during the go-go years 2004-2006 were required to accept penalties. Some lenders offer it to other borrowers as an option on fixed-rate mortgages (FRMs) in exchange for a lower rate.

If you are taking an FRM, have a long time horizon, and would prefer not to be bothered refinancing if interest rates go down, you are the perfect candidate to accept a prepayment penalty in exchange for a lower rate. If it turns out, contrary to your expectations, that you pay off the mortgage within the penalty period, the penalty is tax deductible.

The option may or may not be available, and where it is available, it may not be offered, you have to take the initiative. If you elect to do this, make sure the price of the loan is locked before you do, so that you know that the rate benefit is real. 

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