Sometimes lenders will offer a slightly lower interest rate if you agree to accept the loan with a prepayment penalty. This means that if you pay the loan off within the first 3 years (either by paying more than 20% of principal in any given one-year period, or by paying off the loan completely by selling or refinancing your home), you will owe the lender a penalty.

Typically, this penalty is 2% of the loan balance at the time of early payoff. Thus, on a $250,000 loan balance, the penalty would be $5,000! Lenders impose a prepayment penalty as a way to discourage you from refinancing their loan for the first 3 years.

TIP: I generally recommend that you do not take a loan with a prepayment penalty so that you will always be free to refinance should rates go down, or you need to sell the house. However, if you can obtain the loan with a prepayment penalty at an extremely favorable interest rate, and are certain you will be in the home for at least 3 years, it may be wise to accept the loan with a prepayment penalty.