Prepayment Penalty Often Enforceable

  Question:  When we refinanced the $220,000 mortgage loan on our Phoenix home, the mortgage lender charged a 3 percent prepayment penalty of $6,600 to pay off this mortgage loan.  Can a lender charge a prepayment penalty without showing that they lost money or some other reason?  Are we entitled to an income tax deduction of $6,600 for this penalty?

  Answer:  The amount of any prepayment penalty is established by a clause in the loan documentation (the “note”), and is generally enforceable.  Most mortgage lenders will enforce a prepayment penalty clause when a borrower refinances the mortgage loan with another mortgage lender within the first five years of the original mortgage.

During escrow, the borrower should be given the choice of including the prepayment penalty and have it be negotiated, such as, receiving a lower interest rate or lower closing costs, or both, in exchange for its inclusion.

The good news is that your $6,600 prepayment penalty should be deductible as mortgage interest on your tax return.  However, itemization of your income taxes is necessary and the standard deduction cannot be used.  Whether it makes sense to do so depends on the amount of the prepayment penalty, any other itemized deductions, and whether they are in excess of the standard deduction.