How to Refinance a Mortgage with Pre-Payment Penalty
With mortgage rates still very low, many Americans are thinking about refinancing their mortgage into a lower rate. While this can save them $200 or $300 per month or even more, some of these old loans have an unpleasant extra cost: a prepayment penalty. Prepayment penalties were more common during the housing boom of a decade ago. As housing prices went through the roof and people wanted to finance more and more purchases, banks often used prepayment penalties to lure homeowners into low rate mortgages, while still guaranteeing their profits at the bank.
Here's how a mortgage refinance with a pre-payment works: Banks would drop the rates a bit – perhaps by ¼ of a point – but would then insist that the buyer sign onto a contract that made them pay a penalty if they paid off the mortgage earlier in a certain period. That period was often three to five years.
These mortgage loans were designed to ensure the lender made certain profit. Banks would perform a calculation of risk and they would set the prepayment penalty at 2-4% of the loan. For example, a prepayment penalty of 2% on a $200,000 loan would be $4000.
Borrower must sign disclosures issued by the bank about these penalties, but let's face it: Most home buyers do not read the giant stack of papers they have to sign when they get a mortgage. And in some cases today, as they want to pay off and refinance their loan into a new low rate, those prepayment penalties can really take a bite. If you are thinking about refinancing and you have a prepayment penalty, there are some simple steps to follow to deal with this problem:
#1 Check the Mortgage Contract
First you need to be sure you actually have such a penalty. Refer to your original loan documents and look for a prepayment penalty disclosure document. If you do have this penalty, you will want to start negotiating with your lender to get it reduced.
#2 Read the Prepayment Penalty Fine Print
Some penalties are a single fee, but others may be on a sliding scale that will decrease the longer you have the loan. If you try to get out of the loan after a year, you could pay 4% penalty. After four years, the penalty might only be 1%. If you are getting close to hitting a lower penalty period, you might wait to refinance a few months. Of course, if you talk to your lender, you may be able to get the fee changed.
#3 Calculate the Payments
In some situations, the prepayment penalty will be worth what you pay for it if you are moving into a cheaper loan. For instance, if you have a penalty of $4k now but you are saving $55,000 by refinancing over 15 years and you are not planning to move soon, it is worth doing it.
However, in other cases, you may learn that it is better to wait until the penalty is lower to refinance. A $4k penalty is not attractive if you are planning to move in a year, which will negate the saving from refinancing. So, whether or not it is worth it to pay the penalty and refinance comes down as usual to your specific circumstances.
#4 Call & Negotiate
It is not unheard of for a lender to reduce the prepayment penalty if you ask. You need to call the lender. Start with your loan officer, but if she cannot help you, talk to a manager. They probably will not waive the penalty, but they could reduce it. For instance, if you paid your mortgage for 21 months and a lower penalty starts at two years, they might let it slide and let you get the lower penalty now when you refinance.
#5 Be Nice
No matter how horrible the prepayment penalty is, remember: You signed the loan documents, and the lender holds all the cards. Getting angry will never help. It is fine to ask but you have to ask nicely.
#6 Get Everything in Writing
As you work on getting the prepayment penalty reduced, have everything documented. Write down all of the names of the people you speak with and what they tell you. If someone offers you a reduced prepayment penalty, you have to have it in writing.
Refinancing a mortgage loan into a new lower rate can be a fantastic deal that saves you hundreds of dollars per month. But this savings can be quickly negated by a hefty prepayment penalty. Fortunately, lenders are human beings too, and you may be able to do something about it.
If you follow the above advice and talk to your lender, you may be able to get that fee whittled down enough that it still makes sense to refinance.