A prepayment penalty could cost you thousands of dollars if you pay off your mortgage loan too early. But if you are paying off a mortgage loan backed by the U.S. Department of Housing and Urban Development's Federal Housing Administration -- better known as an FHA loan -- you won't have to worry about such a penalty. FHA loans are not allowed to include prepayment penalties. That doesn't mean, though, that paying off your FHA loan early won't cost you.
Some mortgage lenders charge a prepayment penalty to borrowers who pay off their loans too quickly. "Too quickly" varies by lenders, but many will charge a penalty to borrowers who pay off their loan within its first five years. This penalty will kick in even if borrowers refinance during this time because a refinance does pay off an existing loan. Prepayment penalties vary, but generally run from 2 percent to 4 percent of a mortgage loan. A 2-percent penalty on a $150,000 mortgage loan would come out to $3,000.
A loan insured by the FHA -- the administration only insures mortgage loans, it doesn't originate them -- comes with several benefits. The biggest is that they require down payments of just 3.5 percent of a home's purchase price for borrowers with credit scores of at least 580. Many private mortgage lenders require down payments of as much as 20 percent of a home's price. Another benefit of FHA loans is that lenders who originate them can't charge prepayment penalties. This can save homeowners a significant amount of money if they need to sell their residences shortly after buying because of a job transfer or other unforeseen event.
Even without a prepayment penalty, though, homeowners could suffer a financial hit by selling their homes early and paying off their mortgage loans. The FHA collects a full month's worth of interest even when borrowers pay off their loans earlier in the month. If you sell your home on Aug. 1, the FHA will require that you pay interest on your mortgage loan through the end of August, something that could cost you hundreds of dollars. This penalty remained on the books as of August of 2013. But there has been a movement -- spearheaded by the Consumer Financial Protection Bureau -- to end this practice because, as the protection bureau has noted, it acts as the equivalent of a prepayment penalty.
You might face one more penalty by selling your home early and paying off your FHA-insured loan: You might have to bring money to the closing table. This could happen if your home has lost value since you purchased it. If you owe more on your mortgage loan than what your home is worth, you are underwater, and in such cases the odds are high that you'll have to sell your home for less than what you owe on it. If this happens, you'll need to bring enough money to the closing table to make up the difference. If you sell your home for $200,000 but you owe $210,000 on it, you'll need to provide your lender $10,000 to fully pay off your loan.
- Los Angeles Times: FHA Could Stop Charging Extra Interest
- Bankrate: 6 Steps to a Lower Prepayment Penalty
- Realtor.com: Understanding Prepayment Penalties
- Consumer Financial Protection Bureau. "What Is a Prepayment Penalty?" Accessed Sept. 15, 2020.
- Federal Register. "Ability-to-Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z)." Accessed Sept. 15, 2020.
- Consumer Financial Protection Bureau. "Student Loan Affordability." Page 21. Accessed Sept. 15, 2020.
Don Rafner has been writing professionally since 1992, with work published in "The Washington Post," "Chicago Tribune," "Phoenix Magazine" and several trade magazines. He is also the managing editor of "Midwest Real Estate News." He specializes in writing about mortgage lending, personal finance, business and real-estate topics. He holds a Bachelor of Arts in journalism from the University of Illinois.