Are Prepayment Penalties Illegal?

Q: I thought prepayment penalties are illegal. Is this true? What about owner financing that forbids prepayment of any kind?

A: Thanks for your question. While your question appears simple, the answer is rather complicated. Let’s talk about what you’re obligated to do when you get a mortgage.

When a homeowner buys a home or refinances his or her mortgage, the homeowner will borrow money from a lender. In most cases this new loan will payoff any existing loans leaving only one loan on the property. This loan is generally referred to as a “first mortgage.”

The mortgage is the document that places a lien against your property. It gives the lender a right to sell the property to satisfy the debt if you, the homeowner, fail to pay the amount due under the loan. At the closing, among many documents, the homeowner signs a promissory note and the mortgage. The promissory note is the document that obligates you to repay the debt.

The note is essentially a contract between you and the lender. It obligates you to repay the loan and pay interest on the amount owed. The lender wants to make sure the loan is repaid and that it receives the cash over time. The lender views the loan as an investment and wants that investment to deliver a certain return over the life of the loan. If the interest rate is five percent, the lender wants that cash flow over the length of the loan.

If you payoff the loan early, the lender loses the money it would have made in the future. With that in mind, many lenders protect themselves from early prepayments on loans by forcing the homeowner to pay a penalty if he or she decides to pay off the loan before the end of the loan term. These penalties are known as “prepayment penalties.”

That’s where consumer protection laws have kicked in. In some states, the law says that a lender can’t enforce a prepayment penalty. However, these laws generally apply to a first mortgage on a residential loan and usually only on a homeowner’s primary residence.

So if you take out a loan on a condominium you own as an investment or you have a junior mortgage, the prepayment penalty can, and most likely will, be enforced.

In some states where prepayment penalties are allowed, state laws only permit them to be enforced during the first few years of the loan. Unfortunately, just because a state’s laws forbid or limit prepayment penalties doesn’t mean your loan won’t carry one.

Federally chartered banks follow Federal law, not state law, and recent court decisions have concluded that Federally-chartered banks have the right to ignore State consumer protection laws, including prepayment penalty limits.

As far as owner financing goes, some states permit owners to charge a prepayment penalty, and others do not. If you’re thinking about including one for a loan you are financing, check with a local real estate attorney to find out whether it is legal in your state to do so.

Published: Mar 26, 2004


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