Q: You recently answered a question about a rental property owner deciding whether to refinance into a 15-year vs. a 30-year loan. I bought my house in 1976 for $70,000 with a 30-year loan where the mortgage payment was $410 per month. At some point, I started paying an extra $410 per month on the principal balance, and ended up paying off the loan in 20 years.
Is that a reasonable option instead of refinancing the rental as discussed in the column? It’s not clear from the question whether the lender would allow pre-paying extra on the principal or not. Do lenders sometimes not allow prepayments?
A: Today’s mortgages typically don’t come with pre-payment penalties, and this is true for all Fannie Mae, Freddie Mac and FHA loans. These mortgages, which are government-backed and are used to finance owner-occupied and investment property up to four units (per property), allow you to pay off your loan at any time without a financial penalty.
Commercial and investment property will sometimes carry prepayment penalties, which might be a percentage of the total loan amount, not just the amount that is paid off. Should you pay off the mortgage (or pay down a larger-than permitted portion of the loan) within the penalty period, you would be assessed a fee as specified in the loan documents.
Prepayment penalties on residential properties were popular more than a decade ago, when interest rates were substantially higher than they are. Back then, borrowers happily agreed to a prepayment penalty in exchange for a small break on the interest rate. No one imagined that interest rates even for investment properties would fall to historic lows, and then stay there. The steep decline in mortgage interest rates has made adjustable rate mortgages (ARMs) a better long-term bet than fixed-rate loans and prepayment penalties have become unused products.
They have also given a black eye to lenders who used them to lock in folks with perfectly good credit to less than optimal loans. For that reason, many mortgage lenders have simply done away with loan products that feature prepayment penalties.
Which goes back to your original question: Do lenders allow prepaying the loan balance? Usually they do, without a fee. The way you paid off your loan is a great example of how even a little extra cash thrown at the principal balance can save you years of payments.