Prepayment penalty

Also found in: Dictionary, Thesaurus, Medical, Acronyms.

Prepayment penalty

A fee a borrower pays a lender when the borrower repays a loan before its scheduled time of maturity.

Prepayment Penalty

A fee that a lender may assess if a borrower repays a loan before the scheduled maturity. The prepayment penalty is used to discourage early payment of loans because it deprives the lender of future interest payments. The prepayment penalty is often 2% of the total amount borrowed. Some jurisdictions and organizations prohibit or limit prepayment penalties; if a jurisdiction does not, it may be assess on all loans that do not exclude the possibility in the loan agreement. See also: Prepayment risk.

Prepayment penalty.

Most lenders allow you to prepay the outstanding balance of a loan at any time without a fee, but some lenders charge a prepayment penalty, often about 2% of the amount you borrowed.

If your loan agreement doesn't have a prepayment clause, which excludes a fee for early termination, the penalty may apply.

Many states prohibit prepayment fees, and they're not allowed on any mortgage loans purchased by Fannie Mae or Freddie Mac. But they are allowed in other states, and lenders may offer a lower rate on loans with prepayment penalties because they are locking in their long-term profit.

Similarly lenders who offer to waive closing costs and points when you refinance may impose a penalty if you pay off the loan within the first few years. But if you're not planning to move, this refinancing deal could save you money.

prepayment penalty

A fee paid to the lender for the privilege of paying off a loan earlier than originally agreed upon by the parties.In commercial lending,this is called the defeasance fee and is the amount necessary for the loan manager to take the proceeds of the borrower's payoff,plus the prepayment penalty,and go out in the marketplace to buy an investment with the same return and the same maturity.(Usually that investment will be a government bond.)

Prepayment Penalty

A charge imposed by the lender if the borrower pays off the loan early.

The charge is usually expressed as a percent of the loan balance at the time of prepayment or a specified number of months' interest. Some part of the balance, usually 20%, can be prepaid without penalty. Usually, the penalty declines or disappears as the mortgage ages. For example, the penalty might be 3% of the balance net of the exclusion within the first year, 2% in the second year, and 1% in the third year.

A penalty may or may not apply to prepayment resulting from a home sale. Apenalty that applies whether the loan is prepaid because of a sale or because of a refinancing is referred to as a “hard” penalty. A penalty that applies only to a refinancing is a “soft” penalty.

Advantage of a Prepayment Penalty for Prime Borrowers: Prime borrowers can usually negotiate a lower interest rate in exchange for accepting a prepayment penalty. Investors who buy loans from lenders in the secondary market are willing to accept a lower rate in exchange for a prepayment penalty. The benefit of the penalty to them is that it discourages refinancing if interest rates decline in the future. Lenders will then pass the benefit on to knowledgeable borrowers who ask for it.

Whether it is a good deal depends on the rate reduction, and the size and scope of the penalty. I would consider a 1/4% reduction in rate in exchange for a 2-3% penalty during the first three to five years, payable only on a refinancing, as a good deal. It would be an exceptionally good deal for someone who expects to be in the house a long time.

Penalties on Loans to Sub-Prime Borrowers: In contrast to prime loans, where penalties are an option, penalties are required on most sub-prime loans. Lenders demand them because the risk of refinancing is higher on sub-prime loans than on prime loans. Sub-prime borrowers profit from refinancing if their credit rating improves, even when the general level of mortgage rates does not change. Because of high origination costs and high default costs, sub-prime lending is not profitable if the good loans walk out the door after only two years.

But that doesn't mean sub-prime borrowers have no negotiating power. While they may not be able to negotiate away the penalty entirely, they may well be able to negotiate the specifics. Tell the loan officer, “No longer than five years, no higher than 3%, partial prepayments up to 20% of the balance allowed in any year without penalty, no penalty on sale of the property.”

Surreptitious Penalties: During the heavy refinance periods after 1998, I received hundreds of letters from borrowers who claimed that they were unaware that their loan carried a prepayment penalty until they went to refinance it. In many cases, they alleged that the loan officer had explicitly told them that there was no penalty.

Considering that the penalty must be in the note, and also in the Truth in Lending Disclosure Statement (TIL), both of which are signed by the borrower, how could they not have known?

My best guess, and it is just a guess, is that about half of them did know, but preferred to forget. But that leaves half who were hoodwinked.

It is all too easy, because so many borrowers are so overwhelmed with documents that they sign without reading. Or they read, but what is important in the document doesn't register. It is extremely easy to overlook a prepayment penalty on the TIL.

“Prepayment” lies at the bottom of the TIL, the last piece of information on a long form. It reads as follows:

PREPAYMENT: If you pay off your loan early, you [ ] may [ ] will not have to pay a penalty [ ] may [ ] will not be entitled to a refund of part of the finance charge
This is a strange set of choices. The negative is definite—“you ...  will not have to pay a penalty”—but the affirmative is qualified. The dictionary says that “may” refers to “a possibility”; “may” and “may not” thus mean exactly the same thing. Use of the word “may” suggests falsely that there may not be a penalty. It would not be surprising if this misleading phraseology put borrowers off their guard.

Since a mortgage loan either has a prepayment penalty clause or it doesn't, the disclosure should be rephrased as follows:

PREPAYMENT: Your loan [ ] does [ ] does not have a prepayment penalty clause

The second line under “Prepayment” on the existing TIL form indicates whether or not, in the event of early payment, the lender
will refund “part of the finance charge.” There is no good reason for this being here. Lenders never refund fees to borrowers, and even if they did, borrowers need not be warned about the possibility of lender generosity.

What this item does is cause confusion. Because this confusing and wholly unnecessary statement is placed immediately below the already weak notice of a prepayment penalty, it weakens the penalty notice further by diluting the borrower's attention. The effectiveness of disclosure declines as the amount of other information with which it is packaged rises. The borrower trying to figure out what the refund option means is not concentrating on the penalty option.

It is thus readily understandable why many borrowers signed a TIL but were later surprised to find that they were subject to a prepayment penalty. Don't expect improvements in the TIL anytime soon. Meanwhile, borrowers receiving a TIL for the first time should understand that a check mark against “may” on the first line under “Prepayment” means they have a penalty clause without any doubt whatever and they should just ignore the second line.

References in periodicals archive ?
With prepayment penalties, Freddie Mac notes on its Web site, a borrower should be given the choice of including a prepayment penalty and should never be required to do so.
The reason that is a relevant number is if those borrowers obtained a subprime loan with a prepayment penalty, they are locked into that higher rate loan for the term of the prepayment penalty, unless they want to pay the fee to refinance out of it.
Many state statutes make it difficult to determine if a prepayment penalty complies with legal restrictions.
For example, according to California's laws on predatory lending, the prepayment penalty a lender can charge is determined by the licensure of the lender and the nature of the loan.
In the event that you have to sell your home or refinance, the prepayment penalty lees will be pulled directly out of the equity in your home.
Any lower interest rate they offer you may negate any savings if you have a huge prepayment penalty and are selling your home soon.
A guaranteed interest prepayment penalty, combined with an interest reserve is fantastic racket.
If, on the other hand, you pay the loan off early, the lender keeps the money as a prepayment penalty.
Yield maintenance is similar to the guaranteed interest prepayment penalty we just discussed in the sense that both forms of prepayment penalties require the borrower to compensate the lender for a loss of a future expectation of interest payment--or yield.
The loan was for a 10-year term, a 30-amortization, a rate of 6%, and had a yield maintenance prepayment penalty.
And finally, if Treasury rates drop significantly during the term of the loan, the prepayment penalty will have to go up to compensate the lender for the loss of yield.
So in sum, the yield maintenance prepayment penalty is calculated as the greater of: 1% of the principal being prepaid; or the principal being prepaid multiplied by the present value of the difference between the remaining yield on the mortgage and the yield of a comparable Treasury security.