You can make extra payments whenever you feel so, but the amounts will be usually limited to the maximum of 20% of the original loan’s balance per year while the penalty period lasts (usually the first 3 or 5 years). Only amounts above the 20% are penalized. When the prepayment penalty period is over you are free to make as many extra payments and as often as you feel comfortable with, unless there are some very special provisions in your mortgage contract that may prevent you from doing so.

A prepayment penalty is the jack-in-the-box of the mortgaging world. Most times it is equally annoyingly unexpected (for the borrower), but unlike the dumb toy, it may cause people to lose their money, not just make them produce a polite squeak of a laugh.

A prepayment penalty, if included into a mortgage contract, states that the borrower shall be penalized for a fast repayment of the outstanding balance, a too fast one, that is. What’s too fast? The Note of your mortgage contract contains a schedule of your repayment. Any extra payment ahead of this schedule accelerates the complete repayment of your loan. It saves you quite some money on the interest, but, weird as it may seem, does not make the lender particularly happy. The lender does not want you to get away so soon and easy, he wants you to pay as much interest on the money you’ve borrowed as possible. So, he tries to impose a penalty on you, forcing you to keep your mortgage unchanged for at least 3 or 5 years. It does not mean that extra payments are totally forbidden during this period, but they will probably be limited to the maximum of 20% of the original loan’s balance per year. Everything above that amount is penalized. 

Now, why is it a jack-in-the-box, if everything is so obvious? The problem is that the clause actually containing the penalty statement is presented to the borrower in a very confusing form, which results in a lot of people being totally unaware that they are subject to a prepayment penalty until they actually face it. Namely, a standard mortgage contract will have a Truth in Lending Disclosure Statement attached. A standard Truth in Lending Disclosure Statement closes with the paragraph:

PREPAYMENT:
If you prepay this loan in full or in part, you
◊ may                ◊ will not have to pay a penalty.
◊ may                ◊ will not be entitled to a refund of part of the finance charge.

The word “may” is totally misleading here. Normally it would suggest, that the penalty either does or does not get to be applied depending on the circumstances. In this context, however, the meaning of “may” is actually “will”, as opposed to “will not”. That’s where the confusion lies. Seeing the “may” box ticked, a lot of people get a wrong idea that the possibility of a penalty remains subject to discussion, should the relevant circumstances occur.

As a result, if, for example, the rates drop during the earliest years of a mortgage and the borrower wishes to refinance, he may be unpleasantly surprised to find out, that the refinancing will be a penalty more expensive. How much more – depends on the contract. The amount of the penalty can be a fixed amount (an equivalent of six months of interest, for instance), or a percentage of the outstanding balance, fixed or regressive. For example, the penalty for prepaying a mortgage in its first year may be 5% of the original balance, in the second year – 4%, in the third year – 3% etc.

A penalty that applies to refinancing only is a soft penalty; if it also applies to a home sale – it is a hard penalty. If there is a penalty attached to your contract – make sure you know exactly which kind it is.

A prepayment penalty is not a must in every contract, though. If you are certain that you don’t want any penalties of this sort to be included, make it clear to the lender/broker and check the mentioned above paragraph of the Truth in Lending Disclosure Statement explicitly to make sure that nobody misinterprets your point of view, or when signing just ask, “Show me where it says there is no prepayment penalty,” or “Show me the terms of the prepayment penalty.” If you don’t bring up the subject yourself, you may see the “may” box ticked anyway, sort of “by default”, in the hope that you won’t notice. I hear lots of stories of lenders slipping in seemingly little details, like the little ticked box mentioned above, into contracts just before signing in the hope that the borrower will not care to read everything thoroughly. This rather dirty trick works on so many people, that it is scary.

Why would lenders go into all this trouble to get the penalty included? But for the primary reason – getting as much money from you as possible even if you keep the mortgage for a short period of time, there is another quite pragmatic reason: it makes your mortgage worth around 1% more in the secondary market. It’s all about money, gentlemen. That’s why all the pleads of desperate confused borrowers for a waiver of the prepayment penalty usually fall on deaf ears.

Generally, a prepayment penalty cannot be imposed on you, unless you have a very poor credit score. Borrowers with a good credit score can actually benefit from allowing a prepayment penalty into the contract. A lender must agree to a lower rate – about one eighth to three eighths of a point below the market rate – if such a borrower agrees to have a prepayment penalty included into his contract. It is strongly recommended for a borrower to avoid the hard version of the penalty at all times! However, the profit may turn out quite doubtful if the rates drop within the penalty period but the penalty will make refinancing too costly. It is a sort of gamble. Maybe buying points is a better option for borrowers with a good credit score.

A prepayment penalty is not a permanent provision of a mortgage. It usually applies to the first 3 to 5 years of a mortgage. After that the borrower is free to pay the loan off as fast as he wishes to without any penalties.

I can think of three reasons for that. One of them or any combination of them could result in such an illogical at first glance situation:
• You made an extra payment towards the principal some time ago and now it’s taking effect. The balance has become so low, that even a higher rate cannot push the actual sum of the monthly payment to its previous margin.
• The PMI got cancelled by the lender. Under the provision of the 1999 Federal law, lenders are required to cancel private mortgage insurance on most home mortgage loans made after July 29, 1999 automatically when amortization has reduced the loan balance to 78% of the value of the property at the time the loan was made. An earlier cancellation at 80% of the property’s value is likely to happen only if initiated by the borrower himself.
• If the rate has increased, but the amount of your monthly payment remained unchanged or went up insignificantly and then froze at that level, you may be in trouble, because these are the symptoms of a monthly payment cap in action. Check your mortgage contract: Is your mortgage an adjustable rate mortgage? Does it carry a payment cap? If this is the case, you should immediately look for ways to avoid negative amortization, and fast, before it increases the outstanding balance of your mortgage and wastes a lot of the effort you have put into paying the debt off.

Normally, your monthly payments do not include anything to be paid towards the principal during the interest-only period of your mortgage. On the one hand, it makes these payments lower; on the other hand, when the interest-only period is over you have to face the debt you borrowed years ago in its full size again, only now you have a shorter period of time to repay it. That is why it is strongly recommended to make voluntary extra payments towards the principal during the interest-only period, if your lender allows you to. If he does, make sure the outstanding balance gets adjusted immediately after an extra payment is made. Sometimes a special arrangement for extra payments during the interest-only period is included into the mortgage contract. If you are only planning to take out an interest-only mortgage and intend to make extra payments, pay special attention to these details in your contract. The problem is that many lenders do not adjust the balance during the interest-only period at all, with or without extra payments, unless stated explicitly otherwise in the contract. If the balance gets adjusted (becomes smaller), the amount paid as interest (percentage of the outstanding balance) becomes smaller, too. This way your monthly interest-only payments become even lower (provided the rate is unchanged or drops). If the first adjustment will take place only after the interest-only period is over, all the monthly payments during the interest-only period remain unaltered. It does not mean that you will eventually pay more as interest, though. Everything will be recalculated, your extra payments, as well as the overpaid interest, will be subtracted from the balance, when the time comes. The tricky part here lies in the investment opportunities available to you at the time of your extra payments. It may so happen that an alternative investment would have brought you a better return, if you had invested into it, rather than the mortgage, whose return you will see only in a few years.

For more on Interest-Only Mortgages read here.