Clay Jarvis
Beth Buczynski
If your financial situation changes, through a disruption of or increase in income, for example, even the most carefully chosen mortgage may no longer be a fit. In these cases, you have the option of breaking your mortgage contract — but it’ll cost you a mortgage prepayment penalty.
Mortgage prepayment penalties are how lenders make up for the interest lost when a homeowner pays off some, or all, of their mortgage ahead of schedule. These charges can vary significantly according to lender and mortgage type, so it’s crucial to understand what prepaying your mortgage might cost you.
When do you pay a mortgage prepayment penalty?
Lenders typically charge prepayment penalties in two scenarios: when you exceed your annual repayment limit and when you pay off your entire mortgage early. This can happen when you make a substantial lump sum payment or when you refinance, for example.
The penalties we’ll discuss here only apply to closed mortgages, which have strict prepayment conditions. With an open mortgage, you’re allowed to make additional payments, or zero out your remaining balance, at any time during your mortgage term.
Going beyond your annual prepayment limits
Most closed mortgages include a prepayment privilege, where a borrower can prepay their mortgage up to a certain limit set by the lender. This may include annual increases to your regular mortgage payment or lump-sum payments toward your principal. These prepayments will typically be a predetermined percentage of your original loan amount.
But if you go beyond the limits set by your lender — perhaps it’s a 10% ceiling on how much you can increase your monthly payment, or a 15% cap on your annual lump-sum payment allowance — you’ll face a prepayment penalty.
Paying off your mortgage before your term ends
There are a few reasons why you might pay off your mortgage in full before the end of your term.
One of the most common ones is that you may need to sell your home earlier than expected. You might also receive an inheritance or other windfall and decide that it could help you wipe out your mortgage balance and escape years of paying interest. Even if you just want to refinance your mortgage, repaying your current balance is part of the deal.
Regardless of the reason, you’ll be on the hook for a prepayment penalty if you have a closed mortgage. Because the amount being paid back is higher than if you were simply exceeding your annual prepayment limits, the penalty for paying off your mortgage early could be much steeper.
How much are mortgage prepayment penalties?
Variable-rate mortgages
With closed, variable-rate mortgages, the prepayment penalty is typically three months’ interest on the amount prepaid. Some lenders will base the penalty on your mortgage rate, others might use their prime rate. The more you exceed your prepayment limit, the higher your penalty will be.
Let’s say you have a 5% variable-rate mortgage and go over your annual prepayment limit by $10,000. Your penalty might be a few hundred dollars. But if you pay that entire mortgage off when you have several years left in the term, your penalty will be in the thousands.
Fixed-rate mortgages
If you have a closed, fixed-rate mortgage, the prepayment penalty will likely be either three months’ interest or the amount calculated using their interest rate differential (IRD).
Lenders often have their own IRD calculations, but here’s how they generally operate when borrowers pay off a mortgage in full:
- Your lender finds a mortgage product with a term length similar to your remaining mortgage term. If you have a five-year, fixed-rate mortgage with three years left, for example, your lender will consult its current offerings of three-year, fixed-rate mortgages.
- To determine the IRD rate, your mortgage rate is subtracted from the current posted rate for the applicable product. If your lender’s three-year, fixed mortgage rate is 6.4%, and your original rate was 5%, the IRD rate will be 1.4%.
- The IRD rate is then multiplied by your remaining balance and divided by 12 to determine your monthly amount owed. If you have $400,000 left on your mortgage, this figure would be about $467.
- The monthly amount is then multiplied by the number of months remaining on your term. In this example, that’s 36 months, so you’d be looking at a prepayment penalty of about $16,800.
If you exceed the annual prepayment limit on a closed, fixed-rate mortgage, your penalty shouldn’t be nearly as high as if you paid it off in full. Because you’ll be prepaying a smaller amount, the lender may only charge you three months’ interest.
Avoiding a mortgage prepayment penalty
Here are some ideas that can keep you from being hit with a prepayment penalty:
- Consult your prepayment limits. Before putting an inheritance or especially large tax refund toward your mortgage as an extra payment, check the contract and make sure you’ll stay within the prepayment limits.
- Get an open mortgage. If you want the freedom to pay off your mortgage early, apply for an open mortgage instead of a closed one. The interest rates on open mortgages, however, can be much higher.
If you’re thinking about refinancing to secure more manageable terms, you won’t be able to escape a prepayment penalty. You can, however, talk to your lender about switching from a variable to fixed interest rate on your existing mortgage, or extending your amortization period, to achieve a similar result. Neither should saddle you with any penalties.
Frequently asked questions about mortgage prepayment penalties
Yes. If you exceed your mortgage contract’s annual prepayment limits, or pay off your mortgage in full before the end of its term, you will be charged prepayment penalties.
The prepayment penalty on a closed, variable-rate mortgage is typically three months’ interest. On closed, fixed-rate mortgages, the penalty is generally the higher of three months’ interest or the amount determined by the lender’s interest rate differential (IRD) calculation. Each lender will have its own way of determining these penalties.
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