First-Time Homebuying Expert Says This Question Could Save You Over $100,000
Buying your first home is never easy. You need to save for a down payment, shop around for better mortgage terms, and budget for the extra expenses that sneak up. However, there's one question that you must ask the lender before closing the deal, shares Stacie Rihl, a first-time homebuying expert, in an Instagram post: "Is there a prepayment penalty?" For those unfamiliar with the concept, selected mortgage lenders penalize homebuyers for paying back their loans—in part or full—early to protect their future interest income. This amount covers the underwriting costs, with the balance going to their coffers.
Although prepayment penalties have become passé since the Dodd-Frank Act was enacted, they're far from gone. While borrowers of government-backed mortgages, like the ones from the Department of Veterans Affairs (VA), Federal Housing Administration (FHA), and U.S. Department of Agriculture (USDA), can rest easy, fixed-rate, qualified loan seekers should be concerned. Qualified mortgages are conventional loans with stringent underwriting requirements, abiding by the "ability-to-pay" principle. Conversely, non-qualified loan- and adjustable-rate mortgage (ARM) borrowers are an exception, too.
No prepayment penalties equal interest savings
Depending on a lender's whims, homebuyers can be hit with a flat fee or a few months' interest if they pay early. A more common approach is to apply the sliding scale method, wherein borrowers are charged 2% of the outstanding balance for prepayments made in the first two years of the mortgage's standing. It slips to 1% in the third year and is barred thereafter, per the Dodd-Frank Act. But the point isn't to save on penalties alone — even though they cost significantly, especially after you add the closing costs — but to capture interest savings.
Stacie Rihl elaborates on Instagram on how most borrowers have no grasp of their interest expenses. Or that they can save a fortune if they pay a part of the principal ahead of schedule. Since advance installments don't incur compound interest, you save money — sometimes exceeding $100,000 over the loan's term if all you do is make one extra payment, per her calculations.
We did the math, too, assuming a 30-year mortgage balance of $250,000 (2023's average stands at $244,498 per Experian) at a 7% interest rate (rounding off the Fed's rate of 6.74% at the time of this report). If you prepay 20% of the original mortgage in the second year (prepayment penalties are levied on breaching 20%), your total interest would be $169,344 instead of $348,772, saving you around $179,428.
More savings when the financial conditions turn favorable
Not everyone can prepay the loan a year into their mortgage unless they gain a tax refund or win a lottery (one can dream!). This might detract from the point of bothering with prepayment penalties. But the equation works even if your financial position improves. Wells Fargo made such a comparison when interest rates stood at 3%. In their illustration, a woman named Amber raised her installments to $1000 per month, eventually saving $21,000 in interest and becoming debt-free four years early, in contrast to a man named Ryan, who stuck to the original schedule of a $926 monthly payment.
The differences are extremely glaring, and having the flexibility to pay early becomes important. In fact, considering how the rates are at an all-time high and are expected to come down eventually with the inflation easing, it makes sense to refinance the mortgage at lower interest rates. This will further amplify your savings, especially if you aren't squaring off a part of it with prepayment penalties. So, before signing up for a mortgage, ensure no prepayment penalties apply — lenders are legally required to disclose the details and render a penalty-free offer at closing.