I hear this often when discussing loan programs with clients, "David, there's no prepayment penalty on this loan is there?" Usually, no, but there may be times when a prepayment penalty makes sense.

How can this be?

First, exactly what is a prepayment penalty? It's simply interest funds paid to the lender should the mortgage be retired before an agreed upon term. If you have a 15-year mortgage there's a financial penalty to the lender should you pay off the loan before it's full term. Such penalties vary, but a typical penalty is six months worth of mortgage interest. Most loans with prepayment penalty clauses typically apply during the first three to five years only, with no penalty thereafter. And some states outlaw them completely or place restrictions on them.

There are usually two types of mortgage loans that carry prepayment penalties, sometimes given the monikers "hard" and "soft."

A hard penalty is one that applies to the loan throughout the term, regardless of how the mortgage was retired. Refinancing, selling the home or even making additional principal payments usually define a hard prepayment loan type. Hard prepayments mostly apply to offset other borrower factors like damaged credit or hard to prove income -- and to assure that the lender gets as much interest as possible from the loan.

Less costly, is the soft prepayment. Soft prepayment clauses usually last only 36 to 60 months and do not apply if the house is sold, only if refinanced. Further, most soft prepayment loans allow for extra payments to principal so long as the extra payments do not exceed 20 percent of the principal balance during any 12-month period. On a $100,000 mortgage, you can usually pay off $20,000 extra per year without penalty. Soft prepayments usually are designed to offset a lower initial rate -- in effect, they give the lender some time to re-coup that low up-front rate.

So why do consumers take such loans?

A hard prepayment penalty may apply with a loan issued to someone whose credit is under repair and represents a higher risk of default. In exchange for making a loan under these circumstances, a lender wants to assure a certain return over the life of the loan. Consumers are less likely to pay off a prepayment penalty loan if they have to come up with 6 months interest at closing.

Soft prepayments are sometime offered for the same reason, to insure a specified return on a mortgage loan, but to a borrower with excellent credit. Why would someone with perfectly good credit accept a loan with prepayment penalties?

To get a lower interest rate!

A typical 30-year fixed mortgage could be reduced by .25 percent should the borrower elect a prepayment loan. Usually those who choose a lower rate with a prepayment penalty are planning on keeping the home for an extended period, don't see a need to refinance in the next 3 to 5 years, and realize that if rates go marginally lower it may not pay to refinance. This strategy can be more beneficial for borrowers in times like these with low rates and little likelihood of rates going much lower.

Most lenders offer loans with soft prepayment penalties, but rarely advertise them due to the scary terminology used...the word "penalty." But if you can save on your mortgage interest each month, every month and can live with soft prepayment terms, why not ask what's available? In all cases, of course, you want to check the numbers and think about your future needs. You may be surprised at the answer.

For more articles by David Reed, please press here.

Published: April 12, 2001

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, a veteran Mortgage Banker, successful Real Estate Consultant and author of Your Guide to VA Loans, Mortgages 101: Quick Answers to Over 250 Critical Questions About Your Home Loan, Who Says You Can't Buy a Home!, and Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You, is a former columnist and Contributing Editor with San Diego-based Mortgage Originator Magazine. Reed is President of CD Reed Mortgage Bankers, Austin, TX and is a Past President of the Austin Mortgage Bankers Association.