Most of the clients who come to our firm with concerns about their mortgage want to know what could happen to them if they are unable to make their payments, or how best to limit their financial exposure for payments they have already missed. Far fewer approach us with questions about what they should do if they find themselves in a financial position to pay more than what is currently due and owing on their mortgage, and understandably so. The topic bears discussion, however, as the practice of prepayment – that is, voluntarily paying more than what is owed at a given time - can have significant long-term benefits for the mortgage borrower.
How Does Prepayment Affect a Mortgage?
To understand the benefits of prepayment, one must understand why mortgage companies are willing to lend money to home buyers in the first place: the collection of interest. Mortgage lenders are in the lending business to make money, and they do so by conditioning their loans upon the borrower’s agreement to pay interest over time in addition to paying back the amount initially borrowed (the “principal”). Generally, the longer it takes to repay a loan, the more the mortgage company will eventually collect in interest. The loan agreement will set out how many payments will be made over how many years, allowing the lender to calculate how much of the principal will be left to repay at any given point during the loan’s term and how much interest will accrue over the life of the loan if payments are made on time. The lender can then compare the expected overall interest that they will collect on a proposed loan against the risk of nonpayment to determine whether it is financially worthwhile for the lender to extend the loan. Prepayment throws off the lender’s calculations by reducing the unpaid principal of the loan faster than anticipated, thereby reducing the overall amount of interest that accrues over the lifetime of the loan. To give an extreme example:
Paul purchases a house with a mortgage from Bank of America. The principal on the loan is $300,000, the fixed annual interest rate is 7%, and the loan is to be paid off in equal payments over 30 years. The overall interest that Paul will pay to Bank of America if all payments are made when scheduled would be over $418,000 – more than the amount initially borrowed! In exchange for lending out its money over a 30-year period, Bank of America will make more than double that amount back if all goes well. A good deal for Bank of America, less good for Paul. Now let’s say that one year into the loan, Paul wins the Powerball and suddenly finds himself in a position to pay back the loan immediately. After exactly one year, the amount of principal that Paul will still owe would be a bit over $296,000. Bank of America will have collected around $22,000 in interest. If Paul pays off the loan in its entirety at the one year mark, $318,000 ($296,000 plus $22,000) will be all that Paul pays on a loan that was initially expected to cost him over $700,000 by the end of it.
Most borrowers will not find themselves in Paul’s position, but the general principle stands; paying your mortgage off faster than the loan’s terms call for results in reducing the amount you pay in interest over the life of the loan.
Prepayment Penalties
Paul, obviously, feels great about saving so much on interest (though not as great as he does about winning the lottery). How does Bank of America feel? It depends. With its initial $300,000 paid back, it can loan that money to a new borrower and start collecting interest again. If interest rates have gone up since Paul’s purchase closed, Bank of America may be pleased that it will be making more from its $300,000 investment than it would have made with Paul. But if interest rates have gone down and Bank of America cannot find a borrower who will pay as much as Paul was going to pay, it may be disappointed indeed. And what if Paul’s lender wasn’t Bank of America, but a small lending group, or even an individual? A smaller lender may have been counting on collecting interest over time as a source of passive income and may have laid their financial plans accordingly. They may not have the wherewithal to go out and solicit another borrower if their source of interest is suddenly cut off or reduced.
Some lenders, in order to protect their right to collect interest over the life of the loan and discourage early payment, will include prepayment penalties in their loan agreements. The penalty may be a fixed fee, a certain number of months of interest, or some other amount calculated based on the remaining principal of the loan or how early into the loan’s term the prepayment occurs. More rarely (in Texas, at least), a loan agreement may permit the lender to refuse to accept payments before they come due or even charge the borrower an administrative fee for the time and expense of returning any amount of overpayment to the borrower.
Texas’s Protections Against Prepayment Penalties
Lenders’ ability to attach prepayment penalties to their loans is not unlimited. Section 302.102 of the Texas Finance Code prohibits residential mortgage lenders from implementing any kind of prepayment penalty if the borrower is occupying the purchased property as their homestead and the interest rate on the loan is higher than 12%, with a few exceptions. Thus, high interest lenders, the ones with the greatest incentive to drag out the life of the loan with draconian prepayment penalties, are prevented by law from doing so. Note also that prepayment penalties are only allowed on purchase-money mortgage loans; other loans that use the borrower’s home or its equity as collateral, like a second mortgage or home equity line of credit (HELOC), may not contain prepayment penalties at all, regardless of interest rate. Loans for the purchase of a manufactured home in Texas are also prohibited from containing prepayment penalties.
If you happen to find yourself in the enviable position of being able to pay more than what you are required to on your home’s mortgage, an experienced contract and real estate attorney can help you determine the consequences, good and bad, of mortgage prepayment.
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