When buying a home, you would go through a mortgage lender to secure your home loan. This loan could be any number of types depending on how much money you put down, number of years preferred, any military service time, income versus debt ratio, and so on. As a part of this loan, you would know the amount of money due each month, the date the payment is due, any late penalties that would apply, and the overall length of the loan.
For instance, if you financed your new home with an Adjustable Rate Mortgage or ARM for a 30-year mortgage, your loan would be paid off over that period. However, sometimes people want to pay extra each month or occasionally toward the principal of the loan, which means the loan could be paid off earlier. In this case, if you had a mortgage with monthly payments of $1,000, if you were to pay an additional $1,000 annually, either broken down in monthly payments or in one lump sum, your 30-year mortgage would be reduced to just 18 years. Of course, you could pay more, dropping the loan to even less time.
However, some mortgages have built-in pre-payment penalties. With this, if you were to pay your loan off ahead of schedule, you would be penalized. This pre-payment penalty is calculated as a percentage of the outstanding balance of your loan at the time you pay it off or a specific number of months’ worth of interest. This type of penalty also applies to refinance transactions. When connected to the sale of a home, you might hear the term used as “hard penalty” whereas for refinancing, it is called a “soft penalty”.
In addition, if you have less than perfect credit, the pre-payment penalty might be required since the lender would be carrying a higher risk. However, if you are a sub-prime borrower, chances are you can negotiate the terms of this penalty. For lenders, the pre-payment penalty protects them from risk but also discourages borrowers from refinancing in case interest rates start to drop. Now, if your credit is good and you can make a larger down payment, if you have to go with a pre-payment penalty, you might be able to lock in a better interest rate.
The best option is to find a lender that does not charge pre-payment penalties. In this case, you would have the option of paying more toward the principal of the mortgage loan any time you want, thus reducing the overall payment schedule. As you can imagine, this type of option is best, saving you thousands and thousands of dollars. Therefore, as you shop around for the right lender, make sure you do all you can to avoid a pre-payment penalty.