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My wife and I are in the market for a new house, and we're at the point where we want to comparison shop lenders.

Is it usual for mortgages to have prepayment penalties?

My wife just hates the idea of having debt, so our tendency is going to be to pay it down whenever we have extra cash.

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    In some places (Texas, for example), pre-payment penalties on a mortgage for a primary residence are not allowed by law. – Wesley Marshall Mar 23 '17 at 4:01
  • Fannie Mae and Freddie Mac uniform loans do not have prepayment penalties, so most plain-vanilla loans from national banks and brokers shouldn't have the penalty. Exotic terms, ARMs, construction loans, secondary loans or really local banks where they'll hold the loan are cases where there might be a prepayment penalty. – user662852 Mar 23 '17 at 4:17
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    Please specify your location. Mortgage regulations vary. – Chris W. Rea Mar 23 '17 at 4:36
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    @ChrisW.Rea We're in Missouri in the USA. – David Mar 23 '17 at 14:03
  • @user662852 Consider turning your comment into an answer. It would get an up vote from me if it was. – Ben Miller - Reinstate Monica Mar 23 '17 at 16:27
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It used to be much more common, particularly for sub-prime loans. If you do run into someone offering a loan with a prepayment penalty, you should certainly consider other options.

3

It's not uncommon to have a small penalty if you pre-pay the mortgage in a short time. After all, making the loan isn't free for the bank.

But as Nathan says, if a bank is planning to try very hard to stop you from giving them money, there is probably a reason.

Try to convince your wife: there is nothing inherently wrong with debt. Like anything, too much can be bad for you, but when debt is deployed wisely -- that is almost always, when it is used to finance a capital asset (an asset that produces value) -- it can be a very good thing.

3

Fannie Mae and Freddie Mac uniform loans do not have prepayment penalties, so most plain-vanilla loans from national banks and brokers shouldn't have the penalty. (Fannie Mae rules are categorical; Freddie Mac will buy loans with prepayment if the loan originator documents that a loan without prepayment was offered and the borrower made the choice for other considerations; the uniform instrument they share conforms to the more restrictive rules)

"Mortgage loans subject to prepayment penalties will be ineligible for sale to Fannie Mae"

Fascinating historical discussion of how the two GSEs negotiated the compromise uniform form back in 1975

Exotic terms, subprime, jumbo loans, ARMs, construction loans, secondary loans or really local banks where they'll hold the loan are cases where there might be a prepayment penalty.

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Mortgages with a prepayment penalty usually do not charge points as a condition of issue. The points, usually in the range 1%-3% of the amount borrowed, are paid from the buyer's funds at the settlement, and are effectively the prepayment penalty. Once upon a time (e.g. 30 years ago), in some areas, buyers had a choice of

  • Paying points and having a mortgage with no prepayment penalty.
  • Paying no points and having a mortgage with a prepayment penalty. The penalty usually decreased with time and disappeared after a few years (typically five to seven years).
  • Paying no points and having no prepayment penalty.

This last option usually had a higher interest rate than the first two. It was advantageous for a buyer to accept this option if the buyer was sure that the mortgage would indeed be paid off in a short time, e.g. because a windfall of some kind (huge bonus, big inheritance, a killing in the stock market, a successful IPO) was anticipated, where the higher interest charged for only a few years did not make much of a difference. Taking this third option and hanging on to the mortgage over the full 15 or 20 or 25 or 30 year term would have been a very poor choice. I do not know if all three options are still available in the current mortgage market.

The IRS treats points for original morttgages and points for re-financed mortgages differently for the purposes of Schedule A deductions. Points paid on an original mortgage are deductible as mortgage interest in the year paid, whereas points paid on a refinance must be amortized over the life of the loan so that the mortgage interest deduction is the sum of the interest paid in the monthly payments plus a fraction of the points paid for the refinance. The undeducted part of the points get deducted in the year that the mortgage is paid off early (or refinanced again). Prepayment penalties are, of course, deductible as mortgage interest in the year of the prepayment.

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