Buying a home is one of the most exciting and intense situations you will ever be in. The excitement of owning your first home is somewhat diluted by the massive amount of paperwork you need to sign in order to make your purchase a reality. Due to the vast amounts of paperwork, the explanation of some loan terms may get brushed to the wayside. Borrowers do not help this problem because most are concerned only about their interest rate and their monthly payment. As such, something as seemingly irrelevant as a prepayment penalty may get overlooked.
In a nutshell, a prepayment penalty penalizes you (in the form of money) for paying off your loan early. As such, if you pay off your loan early, you will have to pay a certain amount of money (as designated in your loan contract) as a penalty. The concept behind a prepayment penalty makes sense as the lender makes a majority of its money off of interest payments. Therefore, if you pay off your loan early, the lender cannot make money. As a borrower, you should not care about the lender’s profitability, but having an understanding of prepayment penalties may help you avoid them in the future.
The good news is that prepayment penalties are generally not part of home mortgage contracts. Prepayment penalty clauses are generally reserved for large commercial loans where the lender can earn substantial amounts of money off of interest payments. As such, your home loan most likely will not have such a clause. This does not mean, however, that you should avoid reading your loan contract or not worry about a prepayment penalty. Make sure that you fully understand all of your loan terms or else they could come back to haunt you.
The primary reason that most home loans do not have a prepayment penalty is that they restrict your ability to move. Most people do not live in a home for 30 years (30 years is a standard loan term for a home loan), as such, a prepayment penalty would severely restrict a person’s ability or desire to move. This could have a substantial impact on the residential real estate market.
The biggest problem with prepayment penalties are that they restrict your options with your mortgage. As stated above, most people do not live in their home for 30 years, as such, a prepayment penalty could prevent a person’s ability to sell their home. This problem is compounded if a person has to sell a home because of a move due to a job opportunity or some other reason.
Remember, prepayment penalties generally do not appear in home loan contracts. However, make sure that you completely review all of your loan paperwork to insure that such a term does not appear in your loan contract. The last thing you want is a contract provision that limits your ability to sell your home.