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What is a Prepayment Penalty on Your Mortgage and How is a Calculated?

What is a Prepayment Penalty on Your Mortgage and How is a Calculated?

Prepayment Penalty

Whether you’re a first-time home buyer or have purchased and sold many homes in your life, you may or may not have had to pay a prepayment penalty on your mortgage. However, it is something you should understand when signing the dotted line of your mortgage. Even though it may sound like a simple process, when you decide to sell your current home and buy a new one – it’s a little more complicated than that – especially if you’re not aware of what a prepayment penalty is and the implications it may have in relation to your mortgage loan, when you decide to sell your home or you decide to refinance your mortgage to help consolidate your debt. To help you understand which scenarios you might get dinged with a prepayment penalty on and how the prepayment fee is calculated, we’ve created a basic outline as to how it works.

What is a Prepayment Penalty?

A prepayment penalty is an agreement between the lender and borrower which regulates how much the borrower is allowed to pay off on their mortgage loan, and how often they may do so. In addition to these details, it also outlines how much of a penalty fee is to be paid and what parameters the fee is based upon if this agreement is altered.

Why Would have I Have to Pay a Prepayment Penalty?

There are a variety of reasons as to why you might have to pay a prepayment penalty as it’s possible that you will want to pay off your mortgage as life changes occur. A few of those reasons being that you may want to sell your home before you’ve repaid your mortgage loan in full, perhaps you need to refinance your mortgage as a way of consolidating debt or you may have received an inheritance that you’ve decided to pay off your mortgage loan with. In any of these scenarios you would be paying off your current mortgage loan in full before the end of the term. This also means that the lender who has been collecting interest on the amount that they had lent you, will no longer be able to collect the original amount of interest according to the preset term of the mortgage. Because it had been agreed upon between both parties, that a certain amount of interest would be paid on the loan over the mortgage term, a penalty fee is paid to the lender to compensate for the amount of interest lost.

How is a Prepayment Penalty Calculated?

The amount of your prepayment penalty is tightly tied to the amount outstanding on your mortgage loan and the amount of interest that would have been paid to the lender during the original term. The overall amount of the penalty payment is usually calculated one of two ways.

  1. Your prepayment penalty is calculated as 3 months worth of interest based upon the current mortgage balance.
  2. Your prepayment penalty is calculated using the interest rate differential (also known as the IRD) and the number of months still outstanding on your mortgage term.

With the first option – based on 3 months of interest: If you had a $200,000 mortgage balance which you were being charged 5% interest on, and you had 20 months remaining in your mortgage term. You would be paying $833.33 per month in interest on average. In order to calculate your prepayment penalty with this method, you would multiply your monthly interest payment of $833.33 by 3 months, making your prepayment penalty $2,500.00 if you decided to break your mortgage at that time.

With the second option – based on your IRD: If you had a $200,000 mortgage balance which you were being changed 5% interest on, and the day you wanted to pay off your mortgage in full, the current prime rate is 4%, that would make the difference in rate or your IRD 1%. In order to calculate your prepayment penalty with this method using 1% as your IRD; on your outstanding mortgage loan of $200,000 – Your monthly IRD payment would be $166.66. You would then multiply that amount of $166.66 by the amount of remaining months left in your mortgage term (being 20 months), making your prepayment penalty $3,333.33.

As you can see if you make too large of a lump sum payment on your mortgage during its term or if you break your mortgage when selling your home, you might be on the hook for a larger fee than you realized when signing your mortgage in the first place. Because of the financial crunch paying this fee can have on you as the mortgagor you’ll want to make sure that you obtain a mortgage with not only a great interest rate but also affordable and fair prepayment terms. If you would like to learn more in regards to the options you have in paying out your mortgage when selling or if you would like to investigate further into finding the right mortgage for you – give me a call at 705-737-6161. In a few moments, while reviewing the numbers, we’ll be able to weigh the pros and cons specific to your mortgage needs and decide upon the best plan of action for you to follow.

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