Should I be concerned about a mortgage prepayment penalty?

Posted by  on Feb 17, 2015

Q: I've been talking to mortgage lenders, and I just got a loan proposal from one of them. One thing I hadn't expected is a prepayment penalty. How concerned should I be about a prepayment penalty, and how should I factor it in when I compare mortgage rates and fees?

A: The most important thing to understand about a prepayment penalty is that it will typically apply if you refinance or if you sell your home. So, as remote as the possibility of completely paying off a mortgage early might seem, refinancing and selling a home are common occurrences that can bring the prepayment penalty into play.

In assessing how concerned you should be about the prepayment penalty, there are two things you should consider:

  1. How likely is the penalty to come into play? Prepayment penalties usually apply only for the first five years or less of a mortgage loan. If you have a career that involves relocation or there is some other reason to believe you may move in a few years, a prepayment penalty is more of an issue than if you are confident you are buying this house for the long haul. As for refinancing, today's mortgage rates are so low they reduce -- but don't eliminate -- the likelihood that you would want to refinance within five years.
  2. What benefit do you get for agreeing to the penalty? Borrowers are supposed to get something in return for having these penalties in the loan terms, such as a lower interest rate. So, do not agree to a prepayment penalty unless there is a worthwhile benefit in return.

Perhaps the best way to make apples-to-apples comparisons of mortgage quotes is to decide up front how comfortable you are with a prepayment penalty, based on the answer to the first of the above questions. Then, depending on that answer, try to get all your mortgage quotes on the same basis, either with or without a penalty involved.

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