Can you avoid a prepayment penalty?

May 16th, 2007 by Kenric

Mike T asked “Is there a way to avoid paying a prepayment penalty?” regarding my post from yesterday.

As far as I know, you cannot get out of a prepayment penalty. I have not heard of any banks waiving a prepayment penalty. It’s just not in their best interest to do so. I tried to get Countrywide to do it last year. However, there are ways to lower your penalty or maybe get out of a “soft” prepay penalty.

There are 2 types of prepayment penalties, a “soft” and “hard.”

A “soft” prepayment penalty means that you have to pay a prepayment penalty when you refinance or sell your home to a related party. If you sell your home to an unrelated third party, the prepayment penalty is waived.

If you have a “soft” prepayment penalty and you REALLY want to refinance it, the only way you can escape it is if you sell your home to an unrelated party. You could sell the home to your friend and then buy it back from them immediately. However, the closing costs involved with getting two loans would probably make this method not worth the trouble. In addition, you’d need to find a willing friend. A typical prepayment penalty on a $300,000 loan would be around $8,000, so you if you close two loans for $2,500 each you may save $3,000. I do not know anyone who has done this, but it seems like it would work. Just remember to make sure your friend’s loan doesn’t have a “hard” prepayment penalty.

A “hard” prepayment does not have any escape clauses. Paying off this loan in any way will trigger the prepayment penalty.

A typical prepayment penalty is 6 months of interest based upon any payment to principle over 20% of the remaining loan balance within the past 12 months.

If you have a $300,000 loan at 6% and want to pay it off, the prepayment penalty would we $240,000 X 6% /2 = $7,200. The way the penalty is written is that you are allowed to prepay up to 20% of the remaining balance. Therefore, the first $60,000 you prepay is not penalized.

Notice that the language also has the stipulation “within the past 12 months.” This is put in place so you cannot prepay $60,000 this month and $60,000 next month and just pay off you loan. You have to wait 12 months between 20% payments. Therefore, if you can plan that far ahead and can find the money, you can lower your prepayment penalty.

Take the $300,000 loan example above. If you have many years left on your prepayment penalty and know that you will be selling one year from today, you can make a $60,000 payment to principle today. 13 months from today, you sell your home your prepayment penalty will be based upon the $240,000 loan balance. Your penalty would be $192,000 X 6% / 2 = $5,760. Planning ahead would have saved you $1,440.

With “soft” prepayment penalties, I have them on many of my loans. The one thing you need to think about is whether or not the loan you are getting now is good enough that you will not want to refinance in a year. I had 2 loans at 6% with “soft” prepays. Interest rates would have to drop to around 5.0% for me to refinance these loans. During 2004 when I got these loans, I felt it highly unlikely that rates would drop this low within the next 3 years.

However, if you are getting a loan at 8% today, there’s a good chance that rates may be lower in 2008 or 2009. Therefore, I wouldn’t want a “soft” prepay on any loan today.

As a rule, I would never ever get a loan with a “hard” prepayment penalty. It is just not worth saving a 1/4 or 1/2 percent on your rate. You are talking about trying to save maybe $100/mo vs. paying an $8,000 penalty if you decide to move, change jobs, etc… So I’ll say it again NEVER EVER GET A LOAN WITH A HARD PREPAYMENT PENALTY!