Tips & Special Topics
No Prepayment Penalty with VA Loans
Added January 22, 2009
Zero money down, 100% financing, no private mortgage insurance -- these are often the VA loan benefits that stand out for many VA-eligible borrowers. But, there is another benefit that is often not given the attention it deserves. “No penalty for prepayment” is a standard feature with VA loans and can potentially save borrowers significant amounts of money.
A Prepayment Penalty Mortgage (PPM) is a loan with terms that require a borrower to pay a fee if the loan is paid in full before the end of the loan’s complete duration or a different specified period. Generally speaking, conforming, low interest rate loans do not have prepayment penalties. On the other hand, it is creative, non-conforming loans that do often have prepayment penalties.
Sometimes, the prepayment penalty terms are such that a penalty fee is paid only if the borrower pays the loan early, such as when the borrower pays back all or part of the principal of the loan within the first three years; especially on a loan for which all or most of the payments are usually applied toward interest.
Prepayments occur when a borrower pays all or part of a mortgage debt early. A common prepayment scenario occurs when a loan is refinanced, because one loan is paid off by another. A prepayment can even be triggered by paying extra toward principal in addition to a monthly payment. Many lenders who make PPMs also consider prepayment to have occurred when a house is sold and a loan is paid off.
If offered such a loan, a borrower should carefully consider the pros and cons of these loans against costs and benefits of loans that do not have prepayment penalties. There can be benefits to PPMs such as lower lending fees and smaller interest rates. Borrowers should fully understand all the terms and conditions surrounding prepayment penalties and the cost associated with making a prepayment. PPM terms could cost an unsuspecting borrower thousands of dollars.
The law requires that prepayment penalty terms be disclosed by the lender. So, the borrower should always have the choice to accept or reject a loan that includes a prepayment penalty. Borrowers should always read loan documents carefully before signing to be certain that prepayment terms, if any, are as they expect them to be.
If unsure, a borrower can ask the lender to show where it says in writing “no prepayment penalty”. If there is a prepayment penalty, the provision should be read carefully to be sure the penalty terms are something the borrower feels comfortable with. Seeing prepayment penalty terms in print before signing may prevent unwanted surprises.
A typical prepayment penalty is 80% of 6 months interest. That can translate to thousands of dollars. If an unexpected life change forces a PPM borrower to prepay a mortgage, this penalty can result in a substantial and unpleasant financial hit.
Borrowers should understand that a PPM can hinder their ability to refinance should an opportunity to get a lower rate arise. In the current economy there is no telling how low interest rates will go. And, what might have seemed like a good rate on a PPM might later not seem so good.
If a borrower with a PPM wants, or needs, to get cash out of the equity to make home improvements or pay down debts, he or she might wish he or she had not agreed to the penalty. PPMs can “paralyze” a borrower in this situation, because he or she feels stuck with the loan due to the prepayment penalty terms.
CONCLUSION
The typically lower lending fees and interest rates associated with PPMs can be attractive if borrowers are certain they will own their homes for a long time, will pay their monthly payments, and not pay early, and will not be seeking cash-out refinancing or lower rates while prepayment penalty terms of their loan are in effect. However, if a borrower is uncertain of any of these factors, then a PPM can be risky and costly.
Again, VA mortgages do not include a prepayment penalty. This means the borrower can sell the home at any time and pay off the loan at any time without incurring a prepayment penalty. According to many financial experts, paying just $50 per month extra toward mortgage principal can significantly reduce the duration and the total cost of the loan. With a VA loan, borrowers are “free” to pay more and in doing so, can reduce the total cost of their loans without penalty. VA borrowers also are free to refinance for a lower rate and possibly cash out of equity, too, without a penalty.
