Most borrowers assume they can pay off a mortgage whenever they want without penalty. That's usually true for owner-occupied conventional loans, but it's not universal. Prepayment penalties exist, and they can cost thousands if you refinance, sell, or pay down principal ahead of schedule.
What is a prepayment penalty?
A prepayment penalty is a fee the lender charges if you pay off the loan—or a large portion of it—before a set period expires. Lenders use these clauses to protect their expected interest income, especially on loans with lower rates or higher risk. The penalty typically applies during the first two to five years of the loan term.
For example, a three-year soft prepayment penalty might allow you to sell the property without penalty but charge you if you refinance. A hard penalty charges you regardless of how the loan is paid off.
Which loans commonly include them?
Prepayment penalties are rare on owner-occupied conventional loans but common on:
- · **Investment property mortgages**: Lenders price in the assumption you'll hold the loan longer; early payoff disrupts that model.
- · **Non-QM loans**: Non-qualified mortgages (bank statement, DSCR, interest-only) often carry prepayment clauses in exchange for flexible underwriting.
- · **Commercial mortgages**: Nearly all commercial real-estate loans include some form of prepayment restriction.
- · **Adjustable-rate mortgages (ARMs)**: Some ARMs, especially those with deep initial discounts, include early-payoff penalties during the fixed period.
FHA and VA loans do not allow prepayment penalties. Conventional conforming loans for primary residences rarely include them, but you should always confirm.
How are they structured?
Prepayment penalties come in three main forms:
- · **Flat percentage**: A fixed percentage of the outstanding balance, often 2–5%, charged if you pay off within the penalty period.
- · **Sliding scale**: The penalty decreases over time. For instance, 3% in year one, 2% in year two, 1% in year three, then none.
- · **Yield maintenance or defeasance**: Common on commercial loans. The lender calculates the present value of lost interest, often resulting in a much larger penalty if rates have dropped since origination.
These figures are illustrative; rates and products are subject to change and this is not a commitment to lend.
What to ask before signing
Before you close, confirm:
- · Does this loan have a prepayment penalty?
- · Hard or soft? (Does it apply only on refinance, or also on sale?)
- · How long does it last, and how is it calculated?
- · Can I make extra principal payments without penalty, and if so, how much?
The Alliance take: if you're buying a primary residence and plan to refinance or move within five years, avoid loans with prepayment penalties. On investment or commercial deals, the penalty may be negotiable or worth accepting if the rate and terms are strong enough to offset the risk.
Review your loan estimate and note carefully. Questions? Start an application and we'll walk you through the fine print before you commit.