A mortgage loan is a contract between you and a lender and, as such, can’t be broken without penalty. The type of penalty depends on the severity of the breach. The terms of the contract are outlined in the loan documents, specifically the promissory note. Make sure you thoroughly understand what is expected of you before signing. Once you finalize the deal, you will face penalties if you breach the contract.
A common breach of the mortgage contract is not paying the monthly loan payments by the designated due date. Your payments will be due on the same day each month, with a grace period of 10 to 15 days. So if your payment is due on the first day of the month, and you have a 15-day grace period, you can make your payment without penalty until the 15th of the month. Pay on the 16th, however, and you are in breach of contract, and the lender will assess a late charge as a penalty, typically 5 percent of the payment amount.
A less-common breach of contract on a mortgage loan is a covenant. These are more common on business loans, but can show up in home loans as well, especially on an investment property. A typical covenant is maintaining a debt-to-income ratio up to the bank standards. It will test the covenant on a regular basis, usually annually, using updated financial information. If your ratio is below the contractual number, the lender can assess a fee or raise the rate due to violation of the covenant.
Some mortgages carry pre-payment penalties, especially in the case of a refinance with another lender. Because you are breaking the contract and getting a new loan, it will charge a percentage of the principal balance that you are paying off. So if you pay off a loan with a $150,000 balance with a 2 percent prepayment penalty, you will have to pay $3,000 to break that contract. Prepayment penalties tend to get lower or even disappear the longer you have a loan. It is not uncommon for a prepayment charge to drop off after five to 10 years.
When your loan is declared in default, it means you have breached the contract so severely that the lender is declaring its intent to start a foreclosure action. Typically, default happens after 60 to 90 days of nonpayment. This means no payments whatsoever. If you consistently make late payments, the lender will consider you a “slow pay” and monitor your loan. If you make no payments at all, the lender will exercise its right to claim your property for breach of the mortgage contract.