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Prepayment Penalty

Candlefocus Editor
Prepayment penalty clauses are a common feature of mortgages and serve as a protection for lenders against the loss of interest income. If a borrower pays their loan off in full, or pays a larger amount than the agreed payment each month, then the lender forgoes the predicted interest income for the remainder of the loan period. To protect against this kind of loss, a prepayment penalty clause is added that states a penalty will be applied if the balance is paid down too quickly. The penalty usually applies from the moment a new loan is taken and lasts for up to five years.

During the period up to five years, the lender has a certain income expectation and the borrower enjoys the lower interest rate associated with the loan. Consequentially, if the borrower decides to repay their loan earlier, or in a much larger lump sum than is typical, the lender will mostly likely incur a loss of the expected income. To offset this discouraged behaviour the lender includes a clause requiring a prepayment penalty.

Any prepayment penalties assessed to a borrower must be disclosed to them at the time of loan closing. An up-front disclosure ensures the borrower is aware of any costs associated with reducing their loan quickly, and helps to protect them against any surprises down the line.

In most cases, prepayment penalties are only enforced for a period of five years; however in some instance these clauses may not expire for up to fifteen years from the loan’s origination.

Generally, prepayment penalties are calculated as a percentage of the remaining loan balance. The amount can range from one to five percent, but in some cases it can be even higher. How much a prepayment penalty will cost will depend a great deal on the amount of the remaining loan balance, the current interest rate and the lender's policy. Penalties can also differ between lenders, so it’s important to compare policies prior to obtaining a loan.

Prepayment penalties provide a measure of protection for lenders, but could have a financial impact on the borrower. It’s important to review the penalties of any loan before closing so you can make an informed decision over whether or not the loan is the right one for you.

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