Definition of "Prepayment Penalty"
A charge imposed by the lender if the borrower pays off the loan early. The charge is usually expressed as a percent of the loan balance at the time of prepayment or a specified number of months' interest. Some part of the balance, usually 20%, can be prepaid without penalty. Usually, the penalty declines or disappears as the mortgage ages. For example, the penalty might be 3% of the balance net of the exclusion within the first year, 2% in the second year, and 1% in the third year. A penalty may or may not apply to prepayment resulting from a home sale. A penalty that applies whether the loan is prepaid because of a sale or because of a refinancing is referred to as a 'hard' penalty. A penalty that applies only to a refinancing is a 'soft' penalty. Advantage of a Prepayment Penalty for Prime Borrowers: Prime borrowers can usually negotiate a lower interest rate in exchange for accepting a prepayment penalty. Investors who buy loans from lenders in the secondary market are willing to accept a lower rate in exchange for a prepayment penalty. The benefit of the penalty to them is that it discourages refinancing if interest rates decline in the future. Lenders will then pass the benefit on to knowledgeable borrowers who ask for it. Penalties on Loans to Sub-Prime Borrowers: In contrast to prime loans, where penalties are an option, penalties are required on most sub-prime loans. Lenders demand them because the risk of refinancing is higher on sub-prime loans than on prime loans. Sub-prime borrowers profit from refinancing if their credit rating improves, even when the general level of mortgage rates does not change. Because of high origination costs and high default costs, sub-prime lending is not profitable if the good loans walk out the door after only two years.
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