A penalty that applies to refinancing only is a soft penalty; a penalty that applies to both refinancing and a home sale is a hard penalty.

If your credit score is not very good, I am afraid, you don’t have very much of a choice here. You are forced to do whatever your lender tells you to in order to get the loan. However, try as hard as you can to avoid the hard penalty . Borrowers with a good credit, though, can try to profit from letting a prepayment penalty into their contract. The lender must agree to a lower rate - about one eighth to three eighths of a point below the market rate. 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 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.  Read the rest of this article »