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Prepayment penalties

Why do prepayment penalty clauses matter?

  

Let's look at an example of a situation where taking a slightly higher rate for better prepayment terms will save the borrower a lot of money. For the purpose of the calculation, we will be comparing two hypothetical rates of 2.50% and 2.60%. The actual rate is not what is important to this scenario.... it is the difference in the two rates that matters.

 
 

Let's say a borrower has a mortgage of $400,000, and they have accrued enough higher interest debt where it will save them a lot of money to increase the mortgage with a refinance to pay off the higher interest debt. Let's also say that the borrower is 2 years into a 5 year term, and the refinance rate at this time is 2.50%.

 
 

Both mortgages are non-major bank, or wholesale mortgages (most major banks include posted rates in their penalty calculations, which can cause for much higher penalties).

Table A: Lower rate mortgage of 2.50%

Table B: Higher rate mortgage of 2.60%

Table B: Higher rate mortgage of 2.60%

  Original mortgage amount = $400,000

Monthly payment = $1,812

Balance after 2 years = $ 375,838

 
 

The penalty in this case would be 2.75% of the remaining balance, which comes to $10,357

Table B: Higher rate mortgage of 2.60%

Table B: Higher rate mortgage of 2.60%

Table B: Higher rate mortgage of 2.60%

  Original mortgage amount = $400,000

Monthly payment = $1,812

Balance after 2 years = $376,626

 
 

The penalty in this case would be 3 months interest, which comes to $2,448

 While the balance after 2 years in Table A would be $788 less than the balance in Table B due to the lower rate, the difference in the penalties would be $7,909. Therefore for having taken the slightly lower rate with the more severe prepayment penalty clause, the borrower suffers a loss of $7,121 

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