Q: I understand that you can get a lower mortgage rate if you agree to a prepayment penalty on your loan. What's the trade-off between accepting that kind of penalty and getting the best mortgage rate?
A: There are four key aspects of a prepayment penalty you should focus on:
- How much of a discount are you getting on the mortgage rate?
- What time period does the prepayment period cover? Often, these penalties apply just to the early years of the mortgage, leaving you free to prepay the loan later on.
- How much of the loan can you prepay without a penalty? There may be a threshold amount, such as 20 percent of the original loan, which you could prepay before incurring a penalty.
- What is the potential size of the penalty? Chances are, the penalty would exceed the discount you got on the original mortgage rate.
Prepayment penalties have been criticized because during the housing crisis, they prevented some homeowners with unfavorable mortgages from refinancing. However, if you understand what you are getting into, accepting a prepayment penalty may work in your favor under certain circumstances. However, it is not a simple decision.
That decision largely comes down to the specific numbers you are being offered regarding the four conditions described above. There is also one other very important factor: What are the chances that you will want to refinance or otherwise prepay a substantial amount of this loan during the time period covered by the prepayment penalty?
You are most likely to want to refinance if there is a substantial drop in interest rates, and today's mortgage rates are so low that this seems a fairly unlikely scenario. That makes it more likely that you could benefit from the discounted mortgage rate on one of these loans without ever having to face the prepayment penalty. The catch is that mortgage lenders are much less likely to offer these loans than they were when interest rates were high.