Prepayment penalty on a mortgage

Paying a mortgage ahead of schedule sounds like it should only save interest. Some loan contracts, however, include a charge for certain early payoffs. The borrower may encounter it when selling the home, refinancing, or making a large principal payment, depending on the contract's trigger and applicable law. Read the note.

What the penalty is

A prepayment penalty is a fee the lender may charge when the borrower pays off all or part of a mortgage earlier than the contract allows without a fee. It is not the same as ordinary interest accrued up to the payoff date, and it is not automatically charged whenever a borrower makes an extra payment. The note or addendum states the trigger, formula, and period. The CFPB notes that many penalties apply only when the entire mortgage is paid off during a specified early period; some may address a large partial payoff.

Read the terms carefully. A sale or refinance that pays the balance in full may trigger a penalty even when all monthly payments were made on time. Smaller additional principal payments may be treated differently, but the borrower should not assume the contract excludes them. The Loan Estimate and Closing Disclosure flag whether the loan has a prepayment penalty; the note and any addendum provide the operative terms.

Regulation Z: when a penalty may be included

For a covered transaction within the Ability-to-Repay rule, Regulation Z § 1026.43(g) does not permit a prepayment penalty by default. It may be included only when the penalty is otherwise permitted by law and the transaction meets the rule's conditions. These include an APR that cannot increase after consummation, an eligible Qualified Mortgage category, and a loan that is not a higher-priced mortgage loan under the rule.

When permitted under that section, the penalty cannot apply after three years following consummation. It also cannot exceed 2% of the outstanding balance prepaid during the first two years or 1% during the third year. Those are federal maximums for covered transactions, not a promise that every loan may charge them. A state law, product rule, or contract may prohibit a penalty or impose a shorter period or lower amount.

The borrower must receive an alternative

A creditor offering an eligible covered transaction with a prepayment penalty must also offer an alternative covered transaction without the penalty that satisfies the regulatory conditions. The alternative generally must have a fixed or step rate of the same type, the same loan term, required payment and points-and-fees characteristics, and be one the creditor in good faith believes the consumer likely qualifies for. The comparison gives the borrower a choice between the penalty feature and a qualifying alternative.

If a mortgage broker presents a loan with a penalty, Regulation Z also sets requirements for making an alternative available and presenting it to the consumer. These duties are specific to covered transactions under the rule. Do not turn them into a blanket statement about every mortgage product or assume that the existence of a penalty alone proves the offer was unlawful.

How to compare a loan with and without a penalty

A borrower comparing offers should consider the rate and closing costs along with the penalty period and the fee formula. A loan with a penalty might have a different rate or fee structure, but the borrower should weigh the possible penalty against the expected savings and the chance of moving, refinancing, or making a large payoff. The comparison depends on how long the borrower keeps the loan and what the contract actually charges.

Exam distinctions

• A prepayment penalty is tied to early payoff under contract terms; it is not the interest earned through the payoff date.
• A fee may be triggered by paying off the entire balance, a large partial payoff, or another contract-defined event. Read the scenario.
• Regulation Z's limits apply to covered transactions and have eligibility conditions; do not apply the three-year and percentage limits to every consumer loan without checking scope.
• The federal limits are ceilings, not required charges. A lender may choose a smaller amount or no penalty.
• Keep the prepayment penalty separate from a balloon payment, which is a large amount due at loan maturity, and a payoff statement, which calculates the amount needed to satisfy the loan.

MLO checklist

Identify the loan and whether the federal rule applies. Confirm the feature in the Loan Estimate and final documents. Explain which payoff events may trigger it, the period and calculation, and any qualifying alternative. If state law or product terms may impose a stricter rule, verify that rule before describing what the creditor may charge.