When planning to get a bond, people used to come across the term prepayment penalty, but many of them don't understand what it means. They don't understand the significance of it and many times tend to downplay the relevance of it with their urge to get funds approved. In fact, this is also a poorly explained concept in loan advisory or even not brought up at all.
The term prepayment penalty is usually buried out in the paperwork and only presented to the borrowers as a hurdle at the point where they are enthusiastically preparing to close their mortgage and become debt free. In reality, this may be a costly mistake; one can make if you break the rules regarding pre-payment penalties, whether you know it well or not.
A prepayment penalty is more significant in terms of hard money loans, too, which is another form or standard mortgage loans. Such private loans work against the property as the collateral. In fact, hard money loans work in a bit different way than traditional mortgages. In this, the borrowers make a monthly payment of the interest and the lump sum payment of the capital at the end. In this case, also, the terms regarding prepayment penalties act vital when a situation arises.
For those who are new to it or confused with a need for prepayment penalty in hand, let's explore the concept in a bit more details.
Prepayment loan term
Almost all loan products come with the risk of prepayment to a lender. The borrowers at the first point may find this clause in their favor and consider it as a good thing as they get a set time to repay. The lender not only wants to get the money back, but they expect their returns over the term through your payment of the interests too.
When a borrower wants to prepay, you are cutting the lenders the possibility to earn the expected interest which they planned for. So, to protect them against this risk, lenders put forth a penalty against pre-payment of the loan. The objective is to encourage the borrower to agree with a loan contract as promised or to allow the lenders to gain some additional profit if the loan is prematurely closed.
The primary types of prepayment penalties are:
– Soft prepays, and
– Hard prepays
Soft prepay something which allows the sale of the property without incurring a penalty. However, it will penalize you on refinances a mortgage. On the other hand, hard prepay can penalize you for both home sales and refinance.
The definition of prepaying: Many standard mortgage lenders used to set the payoff to the borrowers as about 20% of the capital loan balance every year. At this point, you may be thinking why anyone may more than 20% of their home loans a year. In fact, while thinking out of the box, paying a mortgage off as early as possible can help in a variety of ways.
– If you happen to sell your home, then it a way to pay off the loan.
– If you are refinancing a loan, then also you may pay off the existing loan with a new one with more comfortable terms.
– If any unexpected funds are coming in your way through an estate or so, this could also help to pay off a loan in hand in full.
Most of the prepays may last for about one to three years, but in such an event where you sell your home or refinance your loan, then the penalty may be quite severe.
Cost of prepaying: This may actually vary from lender to lender. However, on average, it could be up to 80% of the cumulative interest for six months. This mean, you have to pay off about sixmonths worth of interest-only payments to close the mortgage. When calculated at a rate of 80%, this may vary based on the actual loan amount left but could be so expensive in case of any.
For example, if a mortgage for a borrower is at 6.5% and the loan amount is $500,000, then the interest payment would be about $2708.3 monthly. You have to multiply it by six months of payment, which come to 80% of the total, then you may end up with a hefty prepay penalty of about $13,000.
Why prepayment penalties?
Prepay is actually meant to protect lenders or investors who purchase loans. They operate over the calculation as the total number of years they get a lucrative interest as their benefit of running money lending business. If the borrowers tend to pay off quickly regardless of whether by a sale or refinance, then lesser money than what is anticipated will be generated, and the lender ends up at a loss. Every mortgage is offered with an expectation that a certain amount will be collected over a particular time as repayment. If what realized is much lesser than expected, then there is no profit at all. This makes a prepay desirable in typical money lending.
However, it is good news for the borrowers too that the mortgages with a prepayment penalty may have a slightly lower rate of interest if everything else remains equal. As it is more restrictive, if you are well planned, then the overall price may be lower. This is how the ARM prices are kept lower than the fixed rate mortgages.
If you are well planned about buying a home with a mortgage and happy to hold the property for a considerable period, then you can always consider the prepayment penalty loans to enjoy a much lower interest rate. Always ensure that you are committing to prepay by ensuring that it helps lower your rate well enough to make an impact.
In fact, prepay is not so common in general loans nowadays, but they still mostly exist in case of home loans. They are mostly applicable for the non-QM and portfolio loans etc. Always go through the fine prints and watch the paperwork before getting such loans.
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