Some loans may have a pre-payment penalty in the event you pay off the loan early.
You probably won’t see these on conventional or government residential loans, but you may see them on other residential loan products and on commercial loans; the penalty is a certain percentage of the loan amount.
You borrow $200,000 to do a fix and flip from a hard money lender. The hard money lender’s Note states he will collect a penalty of 3% of the loan amount if it is paid off in the first year. You fix up the property and flip it within 6 months. You’ll have to pay a penalty to the lender of $6,000 (3% x $200,000) at closing.
Commercial loans may have a 5-3-1 or 5-4-3-2-1 pre-payment penalty. Each number represents the percentage of the penalty in the year it is paid off. In the 5-3-1 example, the borrower would pay a 5% penalty if paid off in year 1, 3% in year 2, and 1% in year 3. In the 5-4-3-2-1 example, the penalty covers 5 years in a decreasing scale, i.e. 5% in year 1, 4% in year 2, etc.
Just because a loan has a pre-payment penalty does not make it a bad loan. Obviously, you would want a loan that does not have the penalty, but in some circumstances it is unavoidable.
If the loan has a pre-payment penalty, include it in your calculation of the costs up front to see if it makes sense to get the loan.
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