Prepayment penalty

Key Takeaways

• A prepayment penalty is a fee the note charges for retiring the debt ahead of schedule, which protects the lender's expected interest income.
• A hard prepayment penalty applies to any early payoff, including a sale of the property, while a soft prepayment penalty applies only to a refinance.
• Washington permits a prepayment penalty only on an adjustable rate mortgage, and only if it expires at least sixty days before the initial rate reset (RCW 19.144.040).
• Federal rules cap a permitted prepayment penalty at 2 percent of the balance prepaid in the first two years and 1 percent in the third year, with none after year three.

What It Means

A prepayment penalty is a charge written into the Promissory Note for paying a loan off early. A lender prices a loan expecting a stream of interest across a set number of years. When the borrower refinances or sells in year two, that stream stops, and the penalty is how the lender recovers part of what it planned to earn.

Two versions matter, and the exam separates them. A hard prepayment penalty triggers on any early payoff, whether the borrower refinances or sells the house. A soft prepayment penalty triggers only on a refinance and lets the borrower sell without paying it. That difference is not academic, since a hard penalty quietly taxes any sale the borrower did not plan on, such as a job transfer or a divorce.

Where a penalty exists at all, it is limited rather than open ended. Federal rules restrict which closed-end mortgages may carry one, cap the fee as a percentage of the balance prepaid, and shut it off after the third year. State law can restrict it further, and Washington does. The question at the closing table is therefore not whether the fee seems fair, but whether the note contains one, which version it is, and when it expires.

How It Works in Washington

In Washington the restriction is severe. RCW 19.144.040 provides that a financial institution may not make or facilitate the origination of a residential mortgage loan that includes a prepayment penalty or fee that extends beyond sixty days prior to the initial reset period of an adjustable rate mortgage. WAC 208-620-563 states the same rule from the lender's side: you must not collect a prepayment penalty unless on an adjustable rate mortgage, and only where the fee expires at least sixty days before the initial reset. A fixed rate loan has no reset date, so it has no window in which the fee can lawfully sit.

The federal layer narrows the field again in every state. Under the ability-to-repay rule in Regulation Z, a covered closed-end mortgage may include a prepayment penalty only if the loan's annual percentage rate cannot increase after consummation, the loan is a Qualified Mortgage, and the loan is not a higher-priced mortgage loan (12 CFR 1026.43(g)(1)). Even then the penalty cannot be imposed after the first three years of the loan term and cannot exceed 2 percent of the outstanding balance prepaid during the first two years, or 1 percent during the third year (12 CFR 1026.43(g)(2)). Read the two rules together and very little room is left on a Washington home loan, since the state permits the fee only on an adjustable rate mortgage while the federal rule permits it only where the rate cannot rise.

When a Washington borrower does pay a loan off, early or on schedule, RCW 61.24.110 requires the trustee of record to reconvey the property to the person entitled to it upon satisfaction of the obligation and written request. The reconveyance is what lifts the Deed Of Trust off the title.

Example

Priya takes out a fixed rate Qualified Mortgage that is not a higher-priced loan, and the note carries a hard prepayment penalty. Eighteen months later she refinances with a balance of $280,000.

She is inside the first two years, so the federal ceiling is 2 percent of the balance prepaid. Two percent of $280,000 is $5,600, and the escrow officer adds it to her payoff figure. Had she waited until month 25 she would have been in the third year, where the ceiling drops to 1 percent, or $2,800. After month 36 the note may not impose the penalty at all.

The hard or soft question decides one more thing for Priya. Because her penalty is hard, it would have applied to a sale just as it applied to this refinance. A soft penalty would have charged her the same $5,600 on the refinance and nothing at all had she sold the house instead. In Washington, RCW 19.144.040 would have kept that penalty off a fixed rate residential mortgage in the first place.

Common Mistakes and Exam Traps

• A hard prepayment penalty applies to a sale as well as a refinance. A soft penalty spares the sale, and that is the entire difference between the two.
• A prepayment penalty is a term of the promissory note, not of the deed of trust or mortgage. The security instrument secures the debt; the note sets the payoff terms.
• Discount points and a prepayment penalty sit at opposite ends of the loan. Points are paid up front to buy the interest rate down, while a prepayment penalty is charged at the end for leaving early.
• Washington's limit in RCW 19.144.040 is measured from an adjustable rate mortgage's initial reset date, so a fixed rate residential loan has no lawful window for the fee.