When Are Prepayment Penalties Allowed in New Mortgages?

Federal law prohibits some mortgages from having prepayment penalties, which are charges for paying off the loan early.

By , Attorney

For many kinds of new mortgages, the lender can't charge a prepayment penaltya charge for paying off your mortgage early. If your lender can charge a prepayment penalty, it can only do so for the first three years of your loan and the amount of the penalty is capped. These protections come thanks to federal law.

Read on to learn more about what constitutes a prepayment penalty, when prepayment penalties are allowed in new mortgages, and what limitations exist even if a prepayment penalty is allowed.

Laws Designed to Protect Homeowners

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) imposed requirements on mortgage creditors and servicers. The Consumer Financial Protection Bureau (CFPB) was charged with implementing these requirements and adopting new rules pertaining to lending and foreclosures. (Learn about federal laws that apply to foreclosures in Nolo's article Federal Laws Protecting Homeowners: Foreclosure Protections.)

In 2013, the CFPB put forth rules that went into effect on January 10, 2014. The CFPB rules prohibit prepayment penalties for most residential mortgage loans, except under a few specific circumstances.

What Is a Prepayment Penalty?

A prepayment penalty is a charge that the lender imposes on the borrower if the borrower pays all or part of the loan principal before its due date. For example, if you pay off your loan, refinance, or sell your home before a certain date, you could be subject to a prepayment penalty.

When Prepayment Penalties Are Allowed

Under the rules, a prepayment penalty is allowed only if all of the following are true.

  • The loan's APR can't increase after you take out the loan (for example, a fixed rate loan).
  • The loan is a "qualified mortgage." (A qualified mortgage is a type of loan that has certain, more stable terms that help make it more likely that you'll be able to afford your loan, such as a loan term of no more than 30 years and no risky features like negative amortization or interest-only payments.)
  • The loan is not a higher-priced mortgage loan. (A higher-priced mortgage loan is a mortgage with an annual percentage rate higher than a benchmark rate called the Average Prime Offer Rate, which is an annual percentage rate that is based on average interest rates, fees, and other terms on mortgages offered to highly qualified borrowers.)

Restrictions On Prepayment Penalties

Even if a prepayment penalty is permitted, the penalty is subject to several restrictions.

Time Restriction for Prepayment Penalties—Three Years

A prepayment penalty is only allowed during the first three years after the loan is consummated. After three years, a prepayment penalty is not allowed.

When is a loan "consummated"? A loan is consummated when the borrower becomes contractually obligated on the loan. Depending on state law, this could be when the loan documents are signed or when the lender commits to extend credit to the borrower, for example.

Amount Limitations for Prepayment Penalties

For the first two years after the loan is consummated, the penalty can't be greater than 2% of the amount of the outstanding loan balance. For the third year, the penalty is capped at 1% of the outstanding loan balance.

Lender Must Also Offer a Loan Option Without a Prepayment Penalty

In addition, if a lender offers a loan that includes a prepayment penalty, the lender must also offer an alternative loan that does not include a prepayment penalty. In doing this, the lender must have a good faith belief that the consumer likely qualifies for the alternative loan.

The Lender Must Provide You With Information About Prepayment Penalties

Under the CFPB rules, if a loan has a prepayment penalty, the servicer or lender must include information about the penalty:

  • on your periodic billing statement (which is usually sent monthly) or
  • in the coupon book (which is a book provided by the servicer or lender with a page for each billing cycle for a set period, often one year, where there borrower tears off a page or portion of the page and returns it to the loan servicer with each payment), and
  • in interest rate adjustment notices.

(Learn more about the information that mortgage lenders and servicers must provide to homeowners in Nolo's article The Periodic Statement Rule: Monthly Mortgage Statement Requirements.)

Prepayment Penalty Rules Do Not Apply to Pre-2014 Mortgages

The mortgage servicing rules regarding prepayment penalties went into effect on January 10, 2014, and do not apply retroactively. This means that lenders did not have to comply with these rules for mortgages made prior to January 10, 2014.

How to Find Out if Your Loan Has a Prepayment Penalty

If you want to find out if your loan has a prepayment penalty, look at your monthly billing statement or coupon book. You can also look at the paperwork you signed at the loan closing. Usually, paragraphs regarding prepayment penalties are in the promissory note or sometimes in an addendum to the note.

For More Information

To learn more about the CFPB rules pertaining to prepayment penalties (and the other mortgage servicing rules that went into effect on January 10, 2014), go to the Consumer Financial Protection Bureau's website.

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