What is Prepayment Penalty in Mortgage?
In many of the mortgage contracts made between the parties, many times there is a prepayment clause which states that if payment is made in advance by the borrower before the due date of payment, then it shall be treated that the terms and condition of the contract are not adhered by the borrower and hence would be liable to pay the penalty known as the prepayment penalty.
When one party of the contract pays to the other party sum of the amount of any debt before its due date, then it is known as prepayment. Now, if the borrower makes the prepayment of the loan then it would be liable to pay the penalty for the same as mentioned in the contract made by the parties at the beginning of the deal.
This penalty on the prepayment of the loan acts as a tool for discouraging the prepayment as such prepayment leads to loss of the business of the lender of the funds. By charging such penalties, the lender would be able to get compensation for his loss of business.
How Does it Work?
There exists the prepayment risk in the mortgage contracts wherein case the borrower makes the payment of an amount in advance from its due date then the lender might lose his business. So, it is specified generally in the mortgage contract mentioning the details about the calculation of the prepayment penalty in case of the prepayment. The terms and conditions of the clause are to be mentioned by the lender well in advance at the time of completing the deal of such a loan.
There are mainly two types that are associated with the prepayment of the amount due. It includes the following:
- Hard Penalties – These prepayment penalties are levied on the borrower if payment is done in advance from the sale of the home as well as from the refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure..
- Soft Penalties – These prepayment penalties are levied on the borrower if payment is done in advance from the refinancing. Thus in this case, if the borrower pays in advance after selling his home then it would not be liable for the penalty.
Example of Prepayment Penalty in Mortgage
Mr. Tom took the home loan 10 years back from the bank named ABC Bank Limited for a period of 20 years. The current outstanding balance of the loan is $ 1,000,000. At the time of making the contract, it was decided that in case the borrower makes the prepayment of the loan, then he would be liable to pay 3% of the balance amount as the prepayment penalty. Now if the borrower wants to repay the loan then what will be his penalty?
In this case, it is levied on the basis of the percentage of the balance of loan which us 3% as mentioned in the contract.
- = $ 1,000,000 * 3%
- = $ 30,000
How is it Calculated?
There are different ways using which the penalty can be calculated by the lender by mentioning in the terms of the contract. It includes the following:
- A Flat Amount of Penalty: Under this flat amount is mentioned in the contract, which the borrower has to pay in case of the early payment of dues.
- On the Basis of Percentage of Balance of Loan: The penalty for prepayment of loan is sometimes calculated on the basis of the percentage of the remaining balance of the loan.
- Cost of Interest: This can be levied on the basis of the certain number of the month’s interest as per the contract condition.
Why Do They Exist?
When the borrower makes the payment before the due date of the payment of the loan amount, then there are chances that the lender of the money might lose its business. This is so because the lender in case of the prepayment will lose the interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. which otherwise he will get in case the borrower makes the repayment on the due date.
So, in order to protect the interest of the lender and providing the compensation against such loss, prepayment penalty clause is entered in the contract between the lender and borrower where it will be levied on the borrower in case it makes the payment in advance from the date when it actually becomes due. This usually varies from lender to lender as per the terms and conditions of the contract.
How Much Does Penalty Prepayment Cost?
Prepayment penalty costs on the basis of the terms and conditions mentioned in the contract executed by the lender and borrower at the beginning of the contract. It can be calculated on the basis of the percentage of the balance of a loan, or on the basis of the certain number of the month’s interest or it can be the flat amount.
How to Avoid Prepayment Penalties in Mortgage?
In case if the person wants to avoid the prepayment penalties then the one should look for the lender who does not charge the penalty in case of the prepayment of the loan. However in case, the contract is already executed with the clause of the penalty, then the borrower should look at the terms and conditions and check if it can save the penalty by making partial payments because some lenders do not charge prepayment penalties in case of partial repayment.
Also, the prepayment penalties can be avoided by selling the asset in case of the Soft Prepayment penalties instead of refinancing the same.
In case, if payment is made in advance by the borrower before the due date of repayment, then it would be liable to pay the prepayment penalty. The amount of the penalty that will be applicable will be calculated as per the terms and conditions of the contract made between the parties. By charging the penalties, the lender will be able to get compensation for his business.
Generally, there are two types of the prepayment penalties which include hard prepayment penalties which are levied if payment is made by the borrower in advance from either sale of the home or from the refinancing and Soft prepayment penalties which are levied if payment is made by the borrower in advance from the refinancing.
This has been a guide to what is the prepayment penalty in mortgage and its definition. Here we discuss formula to calculate the prepayment penalty amount along with its types and example. You can learn more about accounting from the following articles –