Do Conventional Loans Have Prepayment Penalties?

Conventional loans are a common type of mortgage financing not backed or insured by a government entity, such as the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA). These loans are originated and serviced by private lenders like banks, credit unions, and other financial institutions.

What is a Prepayment Penalty?

A prepayment penalty is a fee a lender may charge if a borrower pays off a loan, either partially or in full, before its scheduled term ends. Lenders impose these fees to compensate for the potential loss of interest income and administrative costs they anticipated earning over the full life of the loan.

Prepayment penalties can be calculated in several ways. Common methods include a percentage of the outstanding loan balance, such as 1% or 2% of the principal amount being repaid. For example, a 2% penalty on a $300,000 outstanding balance would result in a $6,000 fee. Another method involves charging a set number of months’ interest, like six months of interest payments. These penalties apply if a significant portion of the loan or the entire balance is paid off within a specific timeframe, often the first few years of the loan term, such as two or three years.

Prepayment Penalties in Conventional Loans

For most standard conventional mortgage loans, prepayment penalties are not typically applied. This is primarily due to the guidelines set by major secondary market entities like Fannie Mae and Freddie Mac. These government-sponsored enterprises (GSEs) purchase the vast majority of conventional mortgages from originating lenders, which helps maintain liquidity in the housing market. To be eligible for purchase by Fannie Mae or Freddie Mac, conventional loans generally must conform to specific standards, which often prohibit or severely restrict the inclusion of prepayment penalties. This provides borrowers with the flexibility to pay down their loan principal or pay off their mortgage entirely without incurring an additional fee.

When Prepayment Penalties Can Apply

While most conventional loans do not include prepayment penalties, there are specific scenarios and types of loans where these fees might still be encountered. Some lenders originate “portfolio loans,” which they choose to keep in their own portfolio rather than selling on the secondary market to entities like Fannie Mae or Freddie Mac. Because these loans are not subject to the same strict agency guidelines, the originating lender may have more flexibility to include a prepayment penalty clause.

Prepayment penalties may also appear in certain types of non-conforming conventional loans, such as jumbo loans. Jumbo loans exceed the maximum loan limits set by Fannie Mae and Freddie Mac for conforming loans, and as a result, they may carry different terms, including the possibility of a prepayment penalty, particularly for investment properties. Additionally, in some non-qualified mortgage (non-QM) products, prepayment penalties were more common. Non-QM loans cater to borrowers who do not meet traditional lending standards and often come with higher interest rates and sometimes prepayment penalties. Commercial real estate loans, distinct from residential mortgages, frequently include prepayment penalties as a standard practice to compensate lenders for lost interest income.

How to Check for Prepayment Penalties

Borrowers can determine if their loan includes a prepayment penalty by carefully reviewing their loan documentation. The most direct place to look is the promissory note, which is the legally binding document outlining the terms and conditions of the loan. This document will contain a specific clause detailing any prepayment penalty, including how it is calculated and the period during which it applies.

Another important document to examine is the Loan Estimate, which lenders are required to provide within three days of a loan application. This disclosure form clearly indicates whether a prepayment penalty is part of the proposed loan terms. For an existing loan, borrowers can also check their monthly billing statements or contact their loan servicer directly to inquire about any potential prepayment penalties.