A prepayment penalty is a fee some mortgage lenders charge if a borrower pays off their loan too quickly. Sounds a little crazy, right? Well, it kinda is! In this post we are going define prepayment penalties and the prepayment penalty clause.
A clause identifies a particular section of a real estate contract (for those of you who don’t know). There are many types of clauses in real estate, and you are likely to see many of them on your real estate exam.
What is the Prepayment Penalty Clause?
Definition: A prepayment penalty clause states that a lender can penalize a borrower if the borrower pays off the mortgage much sooner than usual.
Yes, you heard that right, if a mortgage has a prepayment penalty clause paying off a loan faster than usual can create a fee for the borrower. The fee occurs if a borrower pays off their loan before a specific period (typically within the first five years).
Why do Lenders Charge Prepayment Penalties?
Prepayment penalties act as protection for banks or lenders against losing interest they typically would earn. Remember, lenders give out loans to make money. If, for some reason, a borrower pays off the loan quickly enough, lenders still want something in return.
It’s worth noting, a prepayment penalty is not that common today, but some traditional mortgages still include prepayment penalty clauses. The good thing is lenders are required to disclose prepayment penalties at closing in the form of a prepayment penalty clause. Just another reason it’s super important to read and understand a contract before you sign it.
How are Prepayment Penalties Calculated?
Well, prepayment penalties clauses vary per contract and depending on the lender. Some penalties can be either a fixed amount or a specific percentage of the remaining mortgage balance.
The first thing you have to do to calculate prepayment penalties is to determine the lender’s method of prepayment penalty by reading through the specific clause. Depending on the technique, you’ll either multiply your remaining principal by your interest rate by the number of months or just pay the fixed amount.
What to Know for the Real Estate Exam
What’s important to understand for the real estate exam is like other clauses, you need to remember what the prepayment penalty clause is.
Remember, the prepayment penalty clause states that a lender can penalize a borrower if the borrower pays off the mortgage much sooner than usual.
A question on the exam you might see is a list of different contract clauses, and you may need to distinguish which-is-which.