Hard vs. Soft Prepayment Penalties on Mortgages
Prepay or prepayment penalties are not necessarily as nasty as they sound. First, there are two different types of prepayment penalties as they pertain to mortgages. The "Hard" penalty means the mortgaged property can NOT be sold or refinanced during the set no-prepayment timeframe; without the borrower becoming liable for a penalty.
The "Soft" prepayment penalty means the mortgaged property can NOT be refinanced during the set no-prepayment timeframe. But, it can be sold at any time without becoming liable for a penalty. Technically, with a soft prepayment penalty, the mortgaged property could be sold the day after it's loan is closed. And, there would be no penalty liability.
Prepayment penalties are optional with many loans... that is, the lender will provide the borrower with the choice of having or not having a prepayment penalty... and also for how long the prepayment penalty timeframe may last. Usually, prepayment penalties are agreed upon by borrower and lender in 1-, 2- or 3-year options.
Why would a borrower choose a 3-year prepayment option? Well, the lender rewards the borrower for choosing a longer prepayment penalty, who is, in effect, agreeing to keep the loan for 3 years, by offering the lowest interest rate. A borrower choosing a 3-year prepayment option will get a lower rate than a borrower who takes a 2-year prepayment option. And, a borrower choosing a 2-year prepayment option will get a lower rate than a borrower choosing only a 1-year prepayment option... and so on.
If a borrower does not want a prepayment penalty, then that borrower will be paying the highest rate. Whether a borrower should have a prepayment penalty or not depends on the borrower's plans for the property.
In the case of an investor, for instance, if the property is being purchased with the idea of not holding it for very long... then, it's probably wise not to have a prepayment penalty and paying the higher rate... especially since the borrower is not going to be paying that mortgage for very long.
If the investor is buying the property with the idea of holding it as a rental, then depending on the type of mortgage, it's rate and so on... agreeing to a prepayment penalty may be the smart thing to do as it will mean a lower mortgage payment.
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