Should You Accept a Prepayment Penalty Clause?
In some states, when a home buyer gets a mortgage, he/she has a
choice - whether to accept a
prepayment penalty clause in the mortgage contract. The right
decision will save money, and the wrong decision will cost money.
This case study shows how to make the right decision.
Mortgage Prepayment Penalties: A Review
Before deciding whether to accept a prepayment
penalty clause in the mortgage contract, a home buyer should
consider the following.
- Normally, prepayment penalties are only charged if the borrower
sells or refinances his/her home in the first
few years of the mortgage. We will call this the
prepayment penalty period.
- Loans with prepayment penalties
usually have lower interest rates than loans without prepayment
Therefore, if a borrower does not intend to sell or refinance
his/her home during the prepayment penalty period, he/she
should accept the prepayment penalty clause in
order to get a lower interest rate.
On the other hand, if the borrower were to sell or refinance during
the prepayment penalty period, he/she would have to pay the penalty.
Then, the question becomes: Are the savings from the lower interest
rate sufficient to cover to cost of the prepayment penalty?
Use this site's
to answer this question. The following case study illustrates the process.
Prepayment Penalty Cost/Benefit Analysis
Cathy is buying a new home. With a prepayment penalty, she can
get a 30-year fixed rate mortgage that has an interest rate of
9.75 percent. The penalty for refinancing within the first
5 years is $7,500. Without a prepayment penalty, she can get the
same mortgage with an interest rate of 10 percent. Suppose Cathy
plans on selling after 4 years. Which option should she choose?
The features of each mortgage appear in the table below.
To keep things simple, assume that there is no down payment, and
neither loan requires points.
To find the low-cost option, Cathy decides to
use the Mortgage Mavin
The first step is to describe the analysis. Here's how.
- Choose "Compare two mortgages" from the Main Goal dropdown box
of the calculator.
- In the "Options" section, check the box for
"Show amortization schedule".
- Under Loan 1, choose "Fixed-Rate Mortgage" as the mortgage type.
- Under Loan 2, choose "Fixed-Rate Mortgage" as the mortgage type.
The calculator then prompts Cathy for the data it needs. She enters
data from the above description into the calculator. For the loan
with a prepayment penalty, Cathy enters $7,500 in the "Other costs
and fees" textbox.
The calculator settings and data entries are shown below.
Describe the Analysis
Describe the Loan
Describe the Costs Paid at Closing
She then clicks the
Calculate button. The calculator produces an amortization schedule that
shows how total mortgage cost varies from month to month. The total cost
figures for the end of year 4 are shown below.
shows that the total cost of the mortgage with
the prepayment penalty is about $5,000 more than the alternative without the
penalty, at the end of the fourth year.
A Final Thought
In this example, the borrower should not choose the mortgage with the prepayment
penalty; since in the 4-year time frame, it is the more expensive option.
However, if she were to keep the home for more than 5 years (the length of
the prepayment penalty period), she should choose the mortgage with the
prepayment penalty. After 5 years, the mortgage with the prepayment penalty
is the less expensive option; since the borrower is no longer required to
pay the penalty, and the interest rate is lower.