No one wants to pay a mortgage prepayment penalty. These penalties can be costly. But at least you can deduct this penalty on your income taxes, something that can lessen, at least slightly, the financial sting.
Lenders sometimes include prepayment penalties that kick in if you pay off your mortgage loan too early, usually within 3 to 5 years. These penalties vary, but you can expect to pay from 2 to 4 percent of your mortgage loan if you trigger one of these penalties. For a mortgage loan of $200,000, the prepayment penalty could range from $4,000 to $8,000. These penalties kick in not only if you pay down your mortgage loan in a short period of time, but also if you refinance an existing mortgage loan that has a prepayment penalty. After all, when you refinance you are paying off one mortgage loan and replacing it with another.
If you do have to pay a prepayment penalty, you can claim it as a tax deduction on your income taxes because the IRS treats the penalty as mortgage interest. This means that you claim it in the same way that you claim the interest that you pay on your mortgage loan during the year.
There is a key exception to the prepayment penalty rule, though. Many homeowners who are refinancing never actually pay their prepayment penalties. Instead, they roll the prepayment penalty into the principal balance of their new loan. If their prepayment penalty is $4,000, and their new refinanced loan has a principal balance of $150,000, they'd actually finance $154,000 instead of paying the prepayment penalty at closing. This has tax implications. If you don't actually pay your penalty, you can't deduct it.
You file your prepayment penalty in the same way that you file the mortgage interest that you paid during the year. To claim this penalty, you have to itemize your deductions on Schedule A of your tax return. This means that you must file your taxes with IRS Form 1040 and that you can't use Form 1040EZ or 1040A. You'll know what amount to enter on your taxes once you receive your Form 1098 from your lender. This form lists how much interest you paid during the year. It will also list whether you paid a prepayment penalty.