Long before you settle on a mortgage lender, one of your interview questions should be, "Is there a prepayment penalty and if so, how much is it?" Unfortunately, too many homebuyers don't understand what a prepayment penalty is, how it works, or even if they are paying it.

Prepayment Penalty

When you take out a mortgage but your credit is less than stellar, banks want to make sure that you will at least stick to your obligation for a few years. Most prepayment penalties come in three-, five-, or even ten-year terms.

Once you have made your mortgage payments for the term of your prepayment period, you no longer face any penalty. If you do pay off your loan before the end of your prepayment period, however, you are going to be on the hook for up to six months of interest on your remaining balance.

How It Works

Most prepayment clauses work this way: If you pay your loan off early no matter the reason, you will have to pay a penalty for it. Some clauses will waive the penalty if you are paying early because you resold the house.

Some mortgage agreements allow you to pay up to 20% above and beyond what you have to pay in any given year without a penalty. Others will penalize you for paying any amount above your agreed upon monthly mortgage payment.

If you refinance your mortgage you do not get credit for the prepayment period that you have already exhausted. The clock starts all over again from the time you refinance. Homeowners who refinance in order to resell within a few years get hit with the prepayment penalty if they do not have a resale waiver written into their mortgage loans.

Why It Is There

A prepayment clause is helpful if you really want to own a home but your credit score is not high enough, or if you can reduce your monthly interest payments by a hundred bucks a month. Think of this clause like your free phone cell phone deals: You get the phone for free as long as you sign up for a two-year contract. If you terminate that contract early, you will be charged the retail cost of the phone. In essence, the phone is not really free.

Banks will cut you some slack on your credit score or your interest rate as long as you guarantee that you will be making regular monthly payments for years to come. Yet the vast majority of homeowners don't buy a primary residence and then flip it two or five years later. It winds up just being an additional cost to taking out a mortgage for most.

Should You Prepay Your Mortgage?

The first thing you have to do when deciding whether or not to prepay your mortgage is to verify whether or not you have a prepayment penalty clause. If your agreement allows you to waive the penalty upon resale, you have one less thing to worry about in that instance.

However, if you still have a year or two left before you avoid the prepayment penalty, waiting may be the best move. Otherwise you could end up paying an extra $10,000 in penalties for the average home.