Perhaps you received an inheritance and want to pay off your mortgage. Or maybe you cleaned up your credit and want to refinance a not-so-favorable loan. These sound like easy adjustments, right? Well, that depends. Prepaying your loan could cost a good deal of money if you have a prepayment penalty in your contract.

Though it seems unfair, mortgage lenders have a reason for imposing prepayment penalties on some loans. Before you sign on the dotted line, find out what you need to know about these clauses and what to do if you have a prepayment penalty on your mortgage.

What is a Prepayment Penalty?

In a mortgage contract, a prepayment penalty clause says that a financial penalty can be imposed if a mortgage gets paid off within a certain time period. This prepayment could result from a refinance, large principal payment or even the sale of the home (which would pay off the mortgage). The penalty is usually based on a percentage of the balance that remained on the loan or a particular number of interest payments.

Mortgage lenders often talk about “soft” prepayment and “hard” prepayments. A “soft” prepayment penalty refers to a loan that gets paid off through a refinance. A “hard” prepayment penalty involves both a sale and a refinance. Both types of prepayments are subject to penalties According to the mortgage contract, both types of prepayments can incur penalties.

Why Impose Prepayment Penalties?

Mortgage lenders impose prepayment penalties because they stand to lose a good deal of interest rate money if a borrower pays the loan off before the agreed-upon time. They may have taken a risk on a borrower with less-than-stellar credit and impose prepayment penalties because sub-prime loans are regularly refinanced within a short time of the loan origination.

While a prepayment penalty is always an option for both parties, lenders have the option to refuse to write the loan without one if they feel they should be compensated for the financial risk.

Working with Prepayment Penalties

Many borrowers actually look for loans with prepayment penalties because they often result in a lower interest rate. A loan with a prepayment penalty could work well for a homeowner looking to lower monthly payments and stay in the home for several years without refinancing.

Prepayment penalties usually get smaller as time goes by and often disappear altogether after the loan has been held in good standing for five years. Most of the time, you can prepay up to 20% of the principal in one year without incurring a penalty, but this amount will vary from contract to contract.

Check your loan documents carefully for any prepayment penalties before you sign the agreement. If you find yourself with an unexpected prepayment penalty, grab your calculator and figure out if the payoff or refinance is worth the extra money you will have to pay. In some instances, it may be wise to wait.