Prepayment Penalty

How Prepayment Penalties Work

A prepayment penalty is a contractual provision that imposes a fee if the borrower pays off the loan principal ahead of schedule. The penalty is typically calculated as a percentage of the remaining loan balance or as a set number of months of interest. For example, a 2% penalty on a $300,000 remaining balance would cost $6,000. Penalties are most commonly triggered by refinancing or selling the property within the first few years of the loan.

Qualified Mortgage Restrictions

The Consumer Financial Protection Bureau's Qualified Mortgage (QM) rule, which took effect in January 2014, places strict limits on prepayment penalties for residential mortgage loans. Under QM rules, prepayment penalties cannot exceed 2% of the outstanding balance in the first two years, 1% in the third year, and are prohibited entirely after year three. Most lenders originating QM loans choose not to include prepayment penalties at all, since the restrictions and compliance burden make them impractical.

Where Prepayment Penalties Still Apply

Prepayment penalties are uncommon in conventional, FHA, VA, and USDA loans originated under current regulations. They are more likely to appear in non-QM loans, commercial mortgages, hard money loans, and some portfolio loans where the lender retains the loan on its own balance sheet. Private mortgage notes between individual parties may also include prepayment penalty clauses, since these transactions are not subject to QM rules. Borrowers considering any of these loan types should review the note carefully for prepayment terms before signing.

Checking for a Prepayment Penalty

The Loan Estimate and Closing Disclosure both include a clear yes-or-no field indicating whether the loan has a prepayment penalty. Borrowers can also review the promissory note, which contains the full terms of any penalty clause. If a penalty exists, the disclosure must state the maximum penalty amount and the time period during which it applies.