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 penalties.

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 mortgage calculator 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.

With Prepayment Penalty		Without Prepayment Penalty
Loan term:	30 years	Loan term:	30 years
Interest rate:	9.75 percent	Interest rate:	10.0 percent
Loan amount:	$250,000	Loan amount:	$250,000
Prepayment penalty:	$7,500	Prepayment penalty:	$0

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 calculator. 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

Main goal:

Options:

Show amortization schedule
Include mortgage insurance
Include hazard insurance

Include property tax
Include prepayments
Include tax deductions

Describe the Loan

Loan 1

Loan 2

Mortgage type:

Loan term (in years):

Loan amount ($):

Interest rate:

Describe the Costs Paid at Closing

Down payment ($):

Points (%):

Other costs and fees ($):

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.

Year	With Prepayment Penalty	Without Prepayment Penalty
4	$353,785	$348,814

The amortization table 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.