A prepayment penalty is a mortgage provision which triggers a lump sum charge in the event that a borrower chooses to refinance a loan or sell a property within the penalty period.
Lenders provide loans to borrowers with the expectation that they will make a minimum amount of money by charging interest. Conversely, borrowers want the lowest interest rates possible. No lender wants to spend three months putting resources into approving a borrower, only to have that borrower refinance with another lender shortly after.
Therefore, a prepayment penalty ensures that a lender makes money in one of two ways:
a borrower keeps a loan active — allowing a lender to collect interest — for a minimum period of time
a borrower disrupts the original loan terms, but pays the lender a prepayment penalty for doing so
For example, if a borrower wishes to refinance her home loan, but has a prepayment penalty period of three years, she will likely defer on refinancing until after the three years to avoid the penalty.
Typical prepayment penalty periods are between six months and five years.
Prepayment penalties vary based on the percentage of total mortgage debt a borrower is still liable for and/or the amount of months left on the loan.
There are also varying levels of prepayment penalty severity. A standard, or soft, penalty only penalizes borrowers for refinancing during the penalty period. A hard penalty penalizes borrowers for both refinancing and selling the property during the penalty period.
California Civil Code Section 2954.9 (a) (1) states that a borrower with a loan for a property containing one to four units is “entitled to prepay the whole or any part of the balance due, together with accrued interest, at any time.”
Prepayment penalties cannot be used by FHA or VA lenders.
Although the purpose of prepayment penalties is to protect lenders’ interests, lenders do not have the right to impose unreasonable punitive measures. For example:
Civil Code Section 2954.9 (b) indicates that any amount that does not exceed 20 percent of the original loan amount can be prepaid regardless of the prepayment penalty period. This refers to a borrower’s right to prepay a sum of the mortgage without penalty.
A lender may not charge a prepayment penalty in the event that a borrower’s property is affected by a natural disaster
Prepayment penalties for loans secured for single family residences may only be charged if the prepayment is paid within seven years after the loan’s execution