Understanding Mortgage Prepayment Penalties

Posted by Hannah Lapin on Mar 26, 2019 9:00:00 AM

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Mortgage loans are expensive to originate. It is not uncommon for consumer mortgages to cost upwards of $9,000. Lenders typically recoup those costs through a combination of upfront fees and interest revenue over the life of the loan. If a borrower pays off a loan shortly after origination, the lender is at risk of losing money on the loan. This is where prepayment penalties come in. A prepayment penalty is a contractual clause that states the borrower is going to pay the lender an additional fee if the borrower pays the loan off early. This isn’t necessarily a “penalty,” however. Let’s dive into how they work and what investors should pay attention to when it comes to prepayment penalties.

How Prepayment Penalties Work

A common prepayment penalty structure — and in fact, Visio’s standard structure — is called a 5/4/3/2/1 structure. This means that if the borrower pays off the loan in year one, they have a 5% prepayment penalty, in year two, a 4% prepayment penalty, and so forth. If your prepayment penalty structure is a 3/0/0, it means that in the first year you pay a 3% fee, and then the penalty goes away after that.

 

So, you might be wondering how this affects the borrower. The answer is, it depends on your investment strategy and when you are looking to pay back the loan.

Prepayment Penalties & Permanent Rental Investors

The rental investors looking to grow a legacy of rental properties and hold on to them long-term (we call these properties “permanent rentals”) are not really affected by the prepayment penalty. Since their investment strategy focuses on the lifetime of the loan, paying off the loan early is a moot point.

 

At Visio, our permanent rental borrowers stick with our standard 5/4/3/2/1 prepayment penalty structure and often pair it with our 30-year fixed rate structure. These borrowers will often also pay higher origination fees in order to lower their monthly payments. Over the span of the loan, these borrowers will ultimately save money.

Prepayment Penalties & Transitional Rental Investors

On the other hand, investors looking to purchase rental properties with flexibility to sell in the foreseeable future (we call these properties “transitional rentals”) are very concerned about prepayment penalties. These investors are interested in market conditions and want to be able to sell the property at the right time without worrying about paying a fee.

 

At Visio, we understand the importance of the transitional rental strategy, which is why our loan programs can be tailored to meet investors’ needs. We currently offer investors the ability to pay extra basis points for a 3/2/1 prepayment structure or a 3/0/0 prepayment structure. That means if they pay off the loan in the first year, they only have a 3% penalty, and after three years, there are no penalties.

 

Try testing your knowledge of prepayment penalties!

 

Transitional investors will often pay lower origination fees (or skip an origination fee altogether) as well as pick a 3-year prepayment penalty option. Although their monthly costs will be higher, paying the least amount of cash upfront is ideal for this strategy.

 

Contact Us to Get Started on Your Investor-Friendly Loan Today

 

More Resources

Related: Understanding Joint Tenancy and Tenancy in Common, Understanding Rental Property Refinancing 

Editor's Note: This post was originally published in March 2019 and has been updated in September 2021 for freshness and accuracy.

Topics: Real Estate Investing