Regulatory roadblocks keep lenders from charging primary residence prepayment penalties

Rental properties can be hit with expensive prepayment penalties if you don’t negotiate them away

 By Jeff Lazerson | jlazerson@mortgagegrader.com | MortgageGrader.com | March 31, 2025

Let’s say you take out a mortgage and want to make extra principal payments to pay the loan balance down - besides the contractually required amortizing mortgage payment (also known as prepaying the mortgage). Or let’s say you want to pay the loan off entirely. Do lenders allow this? If they do, can they stick you with a dollar or a percentage of the loan balance as a prepayment penalty?

Mortgage lenders cannot stop you from paying the mortgage balance down or paying the mortgage balance off earlier than the prescribed amortization schedule. However, a dollar or percentage penalty for a paydown or payoff is allowed under the law.

But since the 2010 Dodd-Frank law was implemented, I have never once known of a prepayment penalty on an owner-occupied or primary residence mortgage. Investor loans are a different story which I will get to shortly.

Under the updated Regulation Z and the ability-to-repay rules birthed by Dodd-Frank, you have to offer a similar loan without a prepayment penalty if you are going to offer a mortgage with a prepayment penalty for owner-occupied mortgages.

“That’s why they are so rare,” said Dennis Doss, owner and founder, Doss Law, LLP.” They don’t prohibit them but put up roadblocks instead.”

In respect to investment properties, aka rentals, lenders can and do charge prepayment penalties. That said, when it comes to mortgage giants Fannie Mae or Freddie Mac, I have never known of a prepayment penalty for a 1–4-unit residential rental property. As far as FHA and VA, they don’t fund investor mortgages.

Why charge a prepayment penalty? Can you say profit center?

Most mortgage lenders earn their income over time. So, if the mortgage is paid off early for example, there is little or no profit for all the effort made to make the loan. The prepayment penalty protects or guarantees the lender’s profit margin.

There are various prepayment penalties. For example, it could be 2% of the outstanding mortgage balance. Or it could be 80% of six months of interest on the existing principal balance. Sometimes you can find an investment property mortgage without a prepayment penalty or negotiate away the penalty but almost always at a higher interest rate.

Sometimes you can be rewarded with a lower interest rate by adding a longer prepayment penalty period. So if you are absolutely certain you won’t be paying the loan balance down or off in say, the next five years, its certainly worth consideration.

Here’s a prepayment penalty example from one lender for whom I do business. 

•          Five-year prepayment penalty offers a 6.875% interest rate
•          Four-year prepayment penalty offers a 7.375% interest rate
•          Three-year prepayment penalty offers a 7.875% interest rate
•          No prepayment penalty offers an 8% interest rate

Sometimes lenders will try some clever maneuvers to avoid the regulations.

Last week I received a call from a long-time client asking me about a purchase money mortgage his first-time buyer son was being offered from a bank. Was this a good deal or not, he wondered aloud.

For $15,000 as a silent, forgivable second mortgage, the lender would buy the rate down to 6.2%. This means no payments and no interest charged on the second lien. The catch was if the borrower refinanced the mortgage within the first year, the $15,000 plus interest would be owed to the lender. And the lender would issue a 1099 to the borrower (income for which the borrower would have to pay taxes on). In the event of a refinance in years two and three, the borrower would owe the $15,000 but without interest or a 1099. After year three, the $15,000 second lien would be completely forgiven.

This transaction is in North Carolina so maybe the rate is a good deal and maybe it isn’t. If it were in California, the rate would be no deal. You can get sub-6% with a $15,000 buydown credit.

The issue I see with financing the rate buydown as an owner-occupied second lien is that the borrower is handcuffed from being able to refinance should rates come down in the near term. He would have to factor in the cost of the refinance along with absorbing the $15,000 hit. Rates would have to take an incredible dive for that to pencil out.

As it concerns home equity lines-of-credit, lenders commonly charge an early cancellation fee of around $500 if the line is paid off within three years.

As an aside, if the lender can’t stick a penalty on a borrower for an owner-occupied loan for example, the lender might go after the mortgage loan originator for lost income. Most investors have clauses stating that if the borrower pays the loan off or pays it down by X amount, that triggers something called an early payoff penalty or EPO against the mortgage loan originator. This generally means the MLO is contractually obligated to pay back either the compensation earned or some dollar amount. Either way it’s expensive and it puts a black mark against the originator’s name-even though the originator has no control over the borrowers’ behavior.

Mortgage loan originators will educate their clients about this nuance for their own benefit, not the consumers. And then they hope the borrower will not act until the EPO runs out. Bottom line is that there is no legal recourse against the borrower if the MLO gets stung by an EPO.

Freddie Mac rate news: The 30-year fixed rate averaged 6.65%, two basis points lower than last week. The 15-year fixed rate averaged 5.89%, five basis points higher than last week.

The Mortgage Bankers Association reported a 2% mortgage application decrease compared to one week ago.

Bottom line: Assuming a borrower gets the average 30-year fixed rate on a conforming $806,500 loan, last year’s payment was $75 more than this week’s payment of $5,177.

What I see: Locally, well-qualified borrowers can get the following fixed-rate mortgages with one point: A 30-year FHA at 5.75%, a 15-year conventional at 5.5%, a 30-year conventional at 6.375%, a 15-year high-balance conventional at 5.875% ($806,501 to $1,209,750 in LA and OC and $806,501 to $1,077,550 in San Diego), a 30-year high-balance conventional at 6.625% and a jumbo 30-year fixed at 6.5%.

Eye catcher loan program of the week: A 40-year fixed rate mortgage, interest-only for the first 10 years at 6.75% with 1 point cost. 

Jeff Lazerson, president of Mortgage Grader can be reached at 949-322-8640 or jlazerson@mortgagegrader.com. His website is www.mortgagegrader.com.

If you enjoyed this article and want to receive weekly mortgage news for FREE, sign up for the newsletter HERE.

* Specific loan program availability and requirements may vary. Please get in touch with your mortgage advisor for more information.