While non-QM loans can help more borrowers get the financing they need, they’re not without their drawbacks.
One major disadvantage is the relatively high interest rate compared to a comparable conventional loan.
Of course, if you can’t qualify for an agency-backed loan, or a standard jumbo, you might just have to accept a higher price.
Beyond that, there’s another pesky feature on many non-QM loans that can make them a bit less attractive.
That’s the “prepayment penalty,” which penalizes the borrower if they sell or refinance the loan during a specified period of time.
And this penalty can be steep, often six months of interest. For example, if you’ve got a loan amount of $750,000 and an interest rate of 8%, we’re talking nearly $30,000.
How Does a Prepayment Penalty Work?
A prepayment penalty is a fee charged by mortgage lenders for paying off a home loan early.
As a refresher, there are three main ways you can pay off a mortgage ahead of schedule.
They include a home sale, where the loan is paid off via proceeds from a buyer.
A mortgage refinance, where the existing loan is paid off via a new home loan.
And just a standard prepayment, where the homeowner decides to pay off the loan before maturity for whatever reason.
The third scenario likely wouldn’t take place if the homeowner was subject to a prepayment penalty.
But the first two could, especially if mortgage rates improved significantly, or the owner really wanted/needed to sell.
So it’s important to consider your plan for the property if your associated home loan is subject to a prepayment penalty.
Hard vs. Soft Prepay: Know the Difference
Note that there are two types of prepayment penalties.
There is a soft prepay, which allows you to sell your property without penalty, but not refinance.
And there is a hard prepay, which penalizes you if you attempt to refinance or sell the property.
That makes the hard prepayment penalty more restrictive.
If you apply for a non-QM loan, be sure to ask if it’s a hard or soft prepay. In many cases, it’s likely going to be a hard prepay for a non-QM loan.
This ensures the bank/investor will actually earn interest for at least a few years before the loan is paid off.
How Long Do Prepayment Penalties Last?
In the past prior to the Global Financial Crisis (GFC), prepayment penalties typically didn’t exceed three years.
But nowadays, it’s not uncommon to see a prepayment penalty last a full five years on a non-QM loan, including DSCR loans.
This means you might not be able to sell your property or refinance the loan for 60 months!
If you do, you’ll be subject to the penalty amount, which can vary by bank and lender.
Some lenders may charge six months of interest, while others might charge 80% of six months interest.
Others may charge you a percentage, such as 5% of any amount prepaid. So it can be quite costly.
Of course, not all lenders tack on such long prepay penalties. You might find a bank that only requires an 18-month prepay, or perhaps a 2-3 year prepay.
Additionally, it’s often an option to buy out the prepayment penalty so you don’t have to deal with it.
However, this is an additional fee that can increase your mortgage rate and/or out-of-pocket costs.
So if you’ve already got a steep interest rate, it might not be practical to buy it out. But you might be able to meet somewhere in the middle with say a 2-year prepay.
This way you’ll be able to sell or refinance without issue if that’s a possibility for your particular property.
Determine Your Plans for the Property Before You Decide on a Prepay
Before you decide what prepayment penalty is right for you (if any), take a moment to map out your plan for the property.
Is it a property you plan to keep for the long-haul, or you have plans to flip it or sell it in the near future?
The same goes for interest rates. If mortgage rates are high, but expected to fall, you might not want to be locked into that loan.
Conversely, if the rate you received is pretty low and you’ve got no issue paying it or offsetting it via rental income, a prepay might not be an issue.
Pay attention to mortgage rate forecasts. If they’re projected to drop significantly, a prepay might be detrimental and block you from a refinance.
If they’re expected to move higher, it might be of little consequence.
One Positive to a Prepayment Penalty.
While prepayment penalties are mostly viewed as a negative, rightfully so, they do provide a benefit.
And that’s a lower interest rate, all being equal. So if you elect to tack on a prepay penalty to your home loan, the mortgage rate should be lower.
After all, you’re agreeing not to sell or refinance for a set amount of time, which gives the investor of the loan some assurances.
This makes you less of a prepayment risk, which theoretically allows the interest rate offered to be lower.
It might not be a major discount, but it could result in an interest rate 0.25% cheaper, which can add up. Or it may just result in lower closing costs.
Either way, it can save you some money if you have no plans to pay the mortgage off ahead of schedule.
Just be sure of your plans (as much as you can be) before you decide on an appropriate prepayment penalty for your loan.
Prepayment Penalty FAQ
Why do lenders impose prepayment penalties?
To ensure the loan isn’t paid off too quickly, which could cause the lender/investor to lose money.
Do all non-QM loans have prepayment penalties?
Not necessarily, although they are quite common on non-QM loans and basically nonexistent on QM loans.
Why are prepayment penalties limited under the QM rule?
In the past they were abused and not properly disclosed to borrowers. For example, a borrower may have been put in a 6-month ARM with a three year prepay. And the loan may have become unaffordable.
What’s the difference between a hard and soft prepay?
A soft prepay allows you to sell a property without penalty, while a hard prepay penalizes you if you sell or refinance the loan.
How long does the prepayment penalty last?
Typically 3-5 years, but it can be just a year or 18 months depending on the bank/lender.
How much is the prepayment penalty?
It depends on the lender, but it’s common to be charged six months interest if you prepay the loan during the prepayment period.
Also note that rules/penalties may vary by state.
Is there a way to avoid the prepayment penalty?
Yes. You might be able to pay to waive the fee or agree to a slightly higher mortgage rate in exchange for no prepay.
Can I still make extra payments to principal?
You probably can, but check your paperwork and ask your loan officer or mortgage broker to be sure. The penalty generally applies when you pay off the full balance.