Several years ago, home prices were surging, lending guidelines were fairly loose and people wanted to buy. As quickly as possible. Those who weren’t buying were taking advantage of favorable interest rates and climbing equity position to refinance and get cash out.
During this record-setting time, a number of the mortgages being placed had clauses imposing a pre-payment penalty, or early repayment charge. Essentially, if a borrower were to pay off their loan before a specific time period had passed—5 or 7 years, for instance—they would have to pay a specific dollar amount or a percentage of their loan in addition to the amount owed.
Why would people agree to a prepayment penalty? For a number of reasons. For those with bumps in their credit history, it could be the only way they could get a loan. For others, it could mean a lower interest rate or better terms.
Is a Pre-payment Penalty Worthwhile?
The question is, if your mortgage has one, is it worth paying a prepayment penalty to refinance? Especially now that rates are at historic lows?
First of all, you need to know exactly what kind of prepayment penalty you have on your loan and how much you’d have to pay if you were to pay it off. The information is included in your mortgage documents; however, one of the fastest ways to find out what you’d have to pay right now is to request a payoff statement from your lender. You may have to pay a fee for this service, but it will give you much of the information you might need.
Get Out Your Calculator
Once you have the information in hand, it’s time to get out a calculator and do some figuring. If you are lowering your interest rate a full percentage point or more, the long-term implications are significant: thousands (and possibly tens of thousands) of dollars over the term of your loan amount. But there might be shorter-term benefits as well.
Suppose, for instance, that you have to pay a $4,000 prepayment penalty in order to refinance. Doing so takes you from a 6% loan to a 4.5% loan and your new loan payment is $250 a month less. You’ll have broken even on the prepayment penalty in just one year.
Of course, deciding whether it is worth paying a prepayment penalty to refinance is dependent on other factors as well, including your long term goals (paying off your loan early versus saving money monthly), how long you’ll be in the home, and whether or not you have an ARM loan with a balloon payment that may ultimately cost you more.
The prepayment penalty answer will vary by borrower and by situation, but especially with the favorable rates we’ve been seeing, it’s a question you should be asking.