Can you prepay without restriction or penalty

During the 1980s, prepayment restrictions almost died out. But by the late 1990s, they were back. Why? To cut down the number of borrowers who refinance and pay off higher rate loans. When rates trend lower, serial refinancers can cost lenders billions of dollars in lost interest and excessive loan origination costs—especially for zero-point loans, negativepoint loans, and low teaser-rate ARMs. Lenders pay loan reps large sales commissions that they hope to earn back over the life of the loan. A quick refi means the lender takes an out-of-pocket loss. Your early prepay to refi at a lower rate cuts short the lender's expected long-term profits.

2To keep it simple, this example ignores principal reduction, which would slightly alter the numbers.

Types of Prepay Restrictions

Most conventional and all FHA/VA loans do permit prepayment in full or in part without penalty. However, most subprime loans restrict or penalize in some way your right to prepay. Also, as a trade-off, some lenders will shave your interest rate by .25 percent or so if you will accept a prepay limit of some sort. If you plan to hold your mortgage for at least three years, I urge you to weigh benefits of this option. Here are a variety of prepay limits common to mortgages.

  • Complete prohibition: Noprepaypermitted. Period! Although sometimes found in commercial-investment mortgages, lenders rarely include such restrictive clauses in mortgages issued to homebuyers.
  • Partial prepay: These clauses permit you to prepay some stated percentage of the loan each year—perhaps 20 percent.
  • Prepay penalty: You may prepay at any time as long as you pay the lender for the privilege. These types of penalties may run as high as 5 percent of your loan's outstanding balance at the time of payoff, such as $7,500 on a $150,000 balance. Sometimes they may require, say, six months of extra payments.
  • Penalty phaseout: Lenders may phase out the penalty over a period of say, three to five years (or longer). On a five-year phaseout, a year-one payoff penalty could cost you 5 percent of the outstanding balance, and a year-five payoff might assess a 1 percent of mortgage balance penalty.
  • Prohibition phaseout: Likewise, a "no payoff permitted" might expire at year three, five, or perhaps ten.

Read the Fine Print

In the early 1980s, I signed for a 10-year term, second mortgage at 16 percent. At the time I applied for the loan, I specifically asked the loan rep, "Will I suffer any penalty if I pay this loan off early?" (Given the high rates of that period, I wanted to refinance as soon as rates came down to more reasonable levels.) The loan rep responded, "No, none at all. There's no prepayment penalty." The lender (a major bank) also advertised these loans "no prepayment penalty." However, several years later when rates had noticeably dropped, I called the bank for its payoff amount. Their figure came out about $800 more than my calculations.

"Your numbers are wrong," I told them. "No, they're not," the bank responded. Alas, it turned out the lender was "right." Although the loan did not include any explicit prepayment penalty, it did impose a penalty for prepayment. (Yes, you read that correctly.) The fine print of the contract specified that the lender would calculate early payoffs according to the rule of 78s. This now less-frequently used method of loan amortization overloads interest payments into the first several years of the loan. Thus, lenders who use this technique (legally) cheat their customers. (The rule of 78s does not in anyway increase the APR disclosure rate!)

Did I complain about fraudulent misrepresentation? You bettcha! Want to guess how well I succeeded in getting my payoff reduced? Zip, zero, nadda.

Learn from my mistake. Don't blindly trust a loan rep to address your concerns. Read the fine print of the contract. Every borrower wants to know, "Is it going to cost me extra to prepay this loan in part or in full?" Clearly, this bank knew its borrowers were concerned about this issue. That's why it advertised, "No prepayment penalty." The bank wanted to deceive its borrowers and found a lawful way to do so. No sensible borrower would have wanted to keep such a loan for its full 10-year term.

I can assure you, many lenders use the same tactics today. Rather than fully explain and address your real concerns, they might answer with partial truths that can subsequently be resolved in the lender's favor by pulling out the paperwork.

Not Just for Prepayment!

I emphasize again, learn from my mistake: Each time you ask the loan rep a question, refuse to accept a mere oral reply. Tell the loan rep that you prefer to see the written language that determines the issue. Apply this safeguard not just for prepayment penalties, but to other material issues such as loan caps, margins, indexes, adjustment periods, closing costs, rate locks, and the topic Secret #87 addresses—assumption clauses.

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