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What are the consequences of prepayment penalties?

My grandfather has lived in his home for 15 years. He has a mortgage that still has five years left. Grandpa has lots of cash now so I suggested that he pay the mortgage off. He said it would cost him too much to do this because of prepayment penalties. Why can’t someone just pay a debt if he feels like it?

ANSWER:

Your grandfather may be correct about prepayment penalties. Property owners do not always have a "right" to repay a mortgage whenever they choose. Courts have held that if those who have mortgages were permitted to pay off their mortgages at any time, then those in the business of providing mortgages could be seriously affected.

The mortgage lender’s and your grandfather’s rights depend upon the provisions of the mortgage contract. Most contracts do allow prepayment, but often prepayment is allowed only with a penalty if more than a certain amount, 20 percent, for example, is prepaid. There may be language in the contract similar to: "Additional payments may be made on the principal at any time without penalty, except any payments that exceed 20 percent of the original principal amount of this loan, during any 12-month period beginning with the date of this note. The undersigned agree to pay, as consideration for the acceptance of such payment, six months’ advance interest on that part of the aggregate amount of all prepayments in excess of the said 20 percent."

The amount of prepayment penalties can vary. Most are not a substantial lump sum, rather a percent of the balance of the loan. Reading your grandfather’s contract should clarify this.

Rules about penalties fall under the jurisdiction of The Federal Home Loan Bank Board (FHLBB), which has set a cap on penalties by limiting them to a maximum of six months’ interest. They also require penalty-free payments of up to 20 percent of the balance of the mortgage amount in any 12-month period.

There are some situations when these rules don’t apply. If a fire destroyed a building, the insurance proceeds could be used to pay off the mortgage without penalty. Prepayment penalties also do not apply when the lender and borrower agree to accelerate the payments.

Remember that every situation is different and obtaining the advice of a professional is the safest way to determine what, if anything, your grandfather should do about his mortgage.

This information is not intended as specific legal advice to anyone and is based upon facts that change from time to time. Individuals should seek legal counsel before acting upon any matter involving the law.

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