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What is a prepayment penalty and why is it incurred?  A mortgage prepayment penalty is the means by which a lender can charge more interest when a mortgage is paid during the penalty period.

The idea seems ludicrous, but the reason why lenders impose prepayment penalties is because if a homeowner pays off a mortgage in advance, the lender is forfeiting the interest payments as well.  Thus, lenders lose money in the long term.

Therefore, a lender will usually charge six months’ worth of interest during the penalty period, which usually falls within the first five years of the mortgage.  This prepayment penalty must be disclosed to a homeowner and although it may provide a lower interest rate to the borrower it is, nonetheless, a costly add-on.

There are two types of prepayment penalties:  soft and hard.  With a soft penalty, the homeowner can sell their home at any time with penalty.  However, if they refinance, the prepayment penalty is enforced.  Conversely, the hard penalty occurs when a home is sold or a mortgage is refinanced.

If you are considering refinancing, avoid prepayment penalties at all costs.  There are several lenders who do not engage in prepayment penalties.  Research many lenders and ask if they have a prepayment penalty stipulation.

There is one exception to the rule, however.  If your credit rating is not in the “excellent” category, a lender may impose the prepayment penalty.  Even though sometime down the road a borrower may opt to refinance at a lower interest rate, this prepayment penalty will still be imposed by lenders.  You can try to negotiate the terms of the penalty, but again, this depends on your circumstances and the lender you select.

Before refinancing or buying a new home, make sure you ask many questions - including whether or not the lender will require a mortgage prepayment penalty.  If you have no alternative, given your financial status and credit rating, you can still re-negotiate the terms of the pre-payment penalty if you have paid your mortgage on time and without any delay for two years or more.