Low Mortgage Rates Put the Focus on Prepayment Penalties

One by one, obstacles to refinancing a mortgage are clearing up. For some home owners, that may leave just one thing standing in the way of a lower mortgage rate - a prepayment penalty on their existing home loan.

Freddie Mac reports that 30-year fixed mortgage rates have been headed downward since peaking in late August. On the housing front, S&P/Case-Shiller reports that home prices have continued their steady recovery over the past year. Combined, those two trends mean that more and more mortgages are emerging from under water while refinance rates are still low enough to represent a worthwhile savings.

However, for some home owners there's still that one last obstacle, the prepayment penalty. Too many people find this obstacle more intimidating than it should be, so what you need to know is how to put it in perspective.

Spreading the Wealth

Prepayment penalties on mortgages are common, though not universal. They penalize the borrower if the mortgage is paid off early, including by refinancing. This kind of penalty might sound like a bad deal, but it really just levels the playing field between borrower and lender. The borrower, after all, can refinance a mortgage if rates fall, but the lender does not have the option of resetting a fixed rate mortgage if rates rise.

A typical prepayment penalty might be two percent of the original loan value. Also, the prepayment penalty might decline or disappear altogether after a period of time, such as the initial five years of the loan. As long as it is in force, that prepayment penalty might seem to preclude refinancing in all but the most extreme circumstances. Remember though, that's a one-time penalty. The percentage you save on a lower refinance rate would lower your interest costs every year for the remainder of the mortgage.

So, it may be worth paying two percent upfront to save half a percent for the next 25 years. The comparison is a little more complicated than it may seem because the amount of loan principal remaining declines over time, so your interest savings from refinancing are diminished in the later years of a loan. Ultimately, your best move is to run the numbers carefully on a mortgage calculator, to see if your interest savings exceed the prepayment penalty and any other expenses associated with refinancing.

Crossing the Threshold

This decision becomes even more complicated if you are approaching the time threshold at which your prepayment penalty no longer applies. For example, if you have a two percent penalty which expires after five years, but can save money by refinancing four years into the mortgage, do you pull the trigger or wait for the penalty to expire?

Given the volatility of mortgage rates, if you can save money by refinancing even after paying the penalty, you may not want to risk waiting more than a few months. It's better to let the prepayment penalty diminish the benefit of refinancing than to risk missing that benefit altogether by waiting. One way to get some perspective on this is to use a mortgage calculator to figure out how much of an increase in your refinance rate it would take for your loss of potential interest savings to equal your prepayment penalty. You may find that it would only take a small increase in rates to wipe out the advantage of avoiding the prepayment penalty, which would strengthen the argument against waiting very long for that penalty to expire.

Looking to the Future

Face it - the typical borrower probably does not think much about prepayment penalties until faced with having to pay one. If your original mortgage has such a penalty in its terms, there isn't much you can do about it, but you can use it as a learning experience for your next mortgage. Pay attention to prepayment penalties when you refinance or the next time you buy a home. A less severe prepayment penalty could well be the tie-breaker between otherwise similar mortgage quotes.

Also, since you are most likely to want to refinance when interest rates fall, you should put less weight on the significance of prepayment penalties when signing up for a loan at low mortgage rates. At high mortgage rates though, a prepayment penalty could prove to be very significant since there is a greater chance you'll have an opportunity to refinance at some point during the loan.

Prepayment penalties are designed to be an obstacle to refinancing, but they are not an insurmountable one. Just keep in mind that lowering your interest rate is a gift that keeps on giving over the remaining life of the loan, and when put in that perspective, a prepayment penalty might just be more palatable than you think.

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