Does a prepayment penalty rule out refinancing?

Posted by  on Sep 26, 2013

Q: I finally have enough equity in my home to refinance, and I could save about 2 percent on the interest rate. However, when I contacted the lender about how refinancing, they said there is a 2 percent penalty for early repayment of the loan, which includes refinancing. Does this mean I shouldn't even think about refinancing unless I can save more than 2 percent in interest?

A: There are two very important differences between the 2 percent you could save on your interest rate and the 2 percent prepayment penalty. One of these differences works in your favor, but the other works against you.

What works in your favor is the fact that when you refinance at a 2 percent lower rate, you would save 2 percent each and every year for the remainder of the loan. In contrast, the prepayment penalty would be a one-time assessment of 2 percent.

The part that works against you is that a prepayment penalty may be based on the full amount of the original loan, whereas the interest you'd save by refinancing would be applied only to your remaining loan balance. If you have a low enough loan balance, the interest you'd save on that balance might not exceed the prepayment penalty.

A refinancing calculator should be able to help you figure this out. Find out for sure whether the penalty applies to the original loan amount, and then figure out what that penalty would be in dollar terms. Then use a refinance calculator to see what you would pay in interest based on your remaining balance and today's interest rates. Compare that to the amortization schedule for your current loan, and see how much interest you would save by refinancing, from now till the end of the loan. If this dollar figure exceeds the dollar amount of the prepayment penalty, you should be able to benefit from refinancing.


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