What is a prepayment penalty on a mortgage?

When you take out a home mortgage loan, you and your lender will both agree to a few key terms. These terms spell out exactly how much you’re borrowing, the interest rate you’ll pay on that loan, and how long you have to pay off the debt.

As time goes on, though, your financial situation may change and allow you to dedicate more money to your loan than you expected. You may even decide that you want to pay off your mortgage ahead of schedule and get out of debt early.

While this can be a great way to pay off your balance and even save thousands in interest charges, there is one potential speedbump to look out for: prepayment penalties.

Most homeowners want to avoid this fee at all costs. However, it can sometimes make sense to pay the penalty if you’d spend more on interest charges by waiting to pay off your loan.

What is a prepayment penalty?

A prepayment penalty is an added fee that some lenders will charge if you decide to pay off some (or all) of your mortgage loan ahead of schedule. 

In most cases, this fee only applies if you pay off your entire mortgage loan balance within a certain number of years after originating the loan. This can also happen if you refinance your home loan shortly after taking out the mortgage. Other lenders might charge a penalty fee if you make extra payments toward your principal balance, though this is rare.

Not all mortgage lenders will charge a prepayment penalty. If this penalty does apply to your mortgage loan, it will have been disclosed in your original mortgage loan agreement. (This is why it’s so very important to read all of the fine print when taking out a loan, and ask questions about any potential fees or charges mentioned!)

If you end up paying a prepayment penalty, you may be able to deduct them as mortgage interest on your taxes.

How much is a prepayment penalty?

As with most fees and terms, the exact details of a mortgage prepayment penalty can vary from one lender to the next. A common prepayment fee structure, however, is a 3/2/1 penalty, also known as a countdown mortgage.

With a 3/2/1 prepayment penalty, the homeowner is charged a 3% penalty fee on the remaining balance of the loan, if they pay off their home mortgage within the first year. If they pay off their loan balance the second year, the penalty fee is 2%. The third year, the fee drops to 1%. In the fourth year of the mortgage loan, the fee no longer applies.

Some lenders may also offer 3/0/0 prepayment penalties — where a 3% penalty applies the first year, then drops off — or another combination. Lenders may also allow borrowers to pay additional basis points on their new mortgage loan, in exchange for a more desirable prepayment penalty structure. If applicable, remember to factor in a prepayment penalty as a cost to selling your house.

Are prepayment penalties legal?

Prepayment penalties are legal, but they cannot be imposed everywhere. Though some exemptions apply (for certain federally-backed mortgage loans), prepayment penalties are not allowed at all in the following states: 

• Alaska
• Arkansas
• Iowa
• Maryland
• New Mexico
• Vermont

Other states have bans on prepayment penalties for certain size mortgage loans or subprime mortgages.

In states where prepayment penalties are allowed, they are generally limited to the first few years of the loan. Lenders may also be limited in how high of a penalty they can charge. 

Also important to note: while we are currently talking about home loans, prepayment penalties aren’t actually limited to mortgages. You could encounter this fee when taking out an auto loan or even a personal loan. 

Which mortgages have prepayment penalties?

If your particular mortgage has a prepayment penalty, you’ll know it. That’s because this penalty is disclosed in your mortgage loan documents, and you would’ve needed to sign that you acknowledged these potential fees. 

Beyond that, some different types of mortgages can have prepayment penalties. Depending on your state, the value of your home, and even your credit rating, you can encounter mortgage prepayment penalties on conventional loans, certain adjustable-rate mortgage (ARM) loans, and more. 

Federally-backed mortgage loans are not permitted to have these early payoff penalties, however. This includes loans backed by the:

• Department of Veterans Affairs (VA loans)
• Federal Housing Administration (FHA loans)
• U.S. Department of Agriculture (USDA loans)

If you live in specific states, prepayment penalties may only be allowed on certain loans or may be banned entirely.

How to avoid prepayment penalties

So, what if you want to get ahead of your debt and pay down your mortgage loan faster than scheduled? Your first step is to review your loan documents to see if a prepayment penalty applies to your home mortgage.

If there is no prepayment penalty on your loan, you can pay off your loan entirely at any time without incurring added fees. This means that if you were to have a sudden financial windfall — like an unexpected inheritance, lottery winnings, proceeds from another property’s sale, or a big bonus at work — you could clear out your mortgage debt without being penalized… even if your loan is relatively new.

If your home mortgage loan does have a prepayment penalty clause, however, you’ll need to determine the best way to avoid those fees while still getting out of debt early. Here are some options:

• Make small (extra) payments: You can still send additional contributions to your loan’s principal balance or even make an extra payment each year, without penalty. That’s because prepayment penalties only apply if you pay off your remaining balance in full within the first few years of your loan. Paying down a portion of the loan now can still save you money in interest.
• Do the math: How long does your prepayment penalty period last, and how much will you pay in interest in that time? Does the penalty fee exceed your interest charges? If not, you might still be better off paying down your loan balance — even with a penalty fee — if it means saving more than that in interest.
• Make your money work for you in the meantime: If you have the funds to pay off your mortgage loan, but want to wait until your prepayment penalty period ends, there’s no reason not to earn as much as you can on that money. This could mean putting it in a high-yield certificate of deposit (CD) or money market account (MMA) until the time is right.

Once you pass the prepayment penalty threshold (which could be anywhere from one to five years, on average), you can finish paying down your remaining balance without any added fees. 

When buying a house, your mortgage lender may or may not include prepayment penalties as a feature of the loan. This penalty can result in thousands of dollars in added costs if you decide to pay off your loan balance within the first few years. Avoiding this penalty — or at least understanding exactly what it entails when you sign your loan agreement — can be an important step in saving as much money as possible on your home.