Understanding Prepayment Penalties

Mortgage loans are expensive to originate. It is not uncommon for consumer mortgages to cost upwards of $9,000. Lenders typically recoup those costs through a combination of upfront fees and interest revenue over the life of the loan. If a borrower pays off a loan shortly after origination, the lender is at risk of losing money on the loan. Enter prepayment penalties. A prepayment penalty is a contractual clause that states the borrower is going to pay the lender an additional fee if the borrower pays the loan off early. This really isn’t a penalty at all. It is a way for the lender to make sure they don’t lose money on a loan.

A standard prepayment penalty could be structured 5/4/3/2/1. This means that if the borrower pays off the loan in year one, they have a 5% prepayment penalty, in year two, a 4% prepayment penalty, in year three, a 3% prepayment penalty, and so forth. So, you might be wondering how this affects the borrower, and the answer is, it depends on your investment strategy. Let’s dive in.

The rental investors looking to grow a legacy of rental properties and hold on to them long term (we call these properties “permanent rentals”) are not really affected by the prepayment penalty. Since their investment strategy focuses on the lifetime of the loan, paying off the loan in the first five years is a moot point.
On the other hand, investors looking to purchase rental properties with flexibility to sell in the foreseeable future (we call these properties “transitional rentals”) are very concerned about the prepayment penalty. These investors are interested in market conditions and want to be able to sell the property at the right time without worrying about paying a penalty fee.