Getting a mortgage and buying a house involves around 300 sheets of paper. And many people are intimidated by the monumental stack of formerly living trees or the terms they don't know printed on them. But with only a few key concepts, you can usually protect yourself from getting very ripped-off.
When looking for a mortgage, most people know to look at the rate, terms, amortization, and monthly payments. While these are obviously very important characteristics of a loan, the key item to look out for --- one that careful people good at math miss --- is a prepayment penalty.
A prepayment penalty is an extra amount of money you need to give the lender if you decide to pay much more of your mortgage debt than is actually due. It's like having to pay your credit card company if you want to pay off your balance in full.
Prepayment Penalty Impact
Without a prepayment penalty, you can usually erase mistakes you made in getting your mortgage through refinancing: if, for example you locked into too high a rate or need to pull equity out of your house for an unexpected reason, you can get rid of the old mortgage by refinancing to a new one and paying whatever closing costs are associated with it.
With a prepayment penalty, you'll have less flexibility because the refinancing will effectively be more expensive and you might be charged if you sell your house. With investments as large and life-changing as real estate, flexibility in the face of unforeseen circumstances is often very valuable.
Why Do People Agree to Them?
People often agree to these clauses because the lender gives them a better rate, more favorable payment terms, or a loan they might not have otherwise qualified for.
Unfortunately, because the penalty is not always obvious or properly disclosed, many people agree to them without knowing that they did.
Lenders Love Prepayment Penalties
The lender benefits because they effectively lock you into a certain payment schedule for a certain number of years and can penalize you for trying to leave them by refinancing.
Though penalties may also be triggered by selling your house, lenders can waive them under certain circumstances.
Freddie Mac's Don't Borrow Trouble series provides more detail about pre-payment penalties.
Bottom line: Look out for any prepayment penalties in your mortgage and understand very carefully what you get in return for them before being locked into one.