Understanding Mortgage Prepayment Penalties

When taking out a mortgage or choosing a new mortgage rate when the current mortgage rate period ends, most people focus on getting the lowest rate available. However, an important aspect that can be overlooked is the prepayment penalty, formally known as an “early repayment charge” (ERC).  

What is an ERC?

An ERC is a fee that lenders sometimes charge if you pay off all or part of your mortgage before the end of your full mortgage term. The ERC is typically a percentage of the loan amount being repaid early, after allowing for any permitted “annual overpayment amount”.  

Whether or not an ERC applies depends, first, on the type of mortgage rate you are on when your early repayment occurs. For example, if the mortgage rate during your current mortgage rate period is a fixed rate, you will almost invariably be subject to an ERC if your repayment occurs before the end of the fixed rate period. On the other hand, if you are on a tracker rate during your current mortgage rate period, you may or may not be subject to an ERC, depending on your lender’s policy with respect to the particular tracker rate deal that you are on. On the other hand, if you are on a standard variable rate or lifetime tracker rate, you will almost certainly not be subject to an ERC.

Whether and how much you pay by way of an ERC also depends on when the repayment occurs during your current mortgage rate period and the annual permitted overpayment amount. For example, if you are on a 5-year fixed mortgage rate and your repayment occurs during the first year of the 5-year rate period, the ERC might be as high as 5% of the amount repaid above the permitted overpayment amount. So far as the permitted overpayment amount goes, most lenders permit repayment of 10% of the outstanding mortgage balance during any calendar year without a prepayment penalty being applied even if you are on a fixed rate during your current rate period.

How Much Is a Prepayment Penalty?

The amount of a prepayment penalty, or ERC, varies depending on the lender and the specific terms of your mortgage. Most often, the penalty, if applicable, is calculated as a percentage of the outstanding mortgage balance that you choose to repay above the permitted overpayment amount.  

For example, suppose you have a £200,000 outstanding mortgage balance, your annual permitted overpayment amount is 10% of the mortgage balance, you are in the first year of a 5-year mortgage rate period, when an ERC rate of 5% applies, and you want to repay your entire mortgage balance. As the annual permitted overpayment amount is 10%, you will pay an ERC on £200,000 minus (£200,000 x 10%) = £180,000. As the ERC rate is 5%, you will pay an ERC of £180,000 x 5% = £9,000.

Avoiding Prepayment Penalties

One of the best ways to avoid these penalties is to choose a mortgage rate that does not include an ERC. For example, some short term variable or tracker rates do not attract ERCs.  

If you are not on a rate which avoids ERCs, however, you could consider timing your repayment to coincide with the end of your current mortgage rate period. After this period, many mortgages revert to the lender’s standard variable rate, at which point ERCs typically no longer apply. Paying off your mortgage at that point in time can help you avoid penalties.  

Alternatively, if you cannot wait until the current mortgage rate period ends, consider how long you can realistically wait to make the repayment. For example, you might be in the first year of a 5-year mortgage rate period, when the ERC rate is 5% of the repayment amount above the permitted overpayment amount. However, the ERC rate might go down to, say, 2% in the fourth year and 1% in the fifth year of your current mortgage rate period. Consider how long you can realistically wait to make the repayment in order to reduce the ERC as much as possible.

On the other hand, if you are not in a hurry to repay, but would, nevertheless, like to make significant reductions in your outstanding mortgage balance, a strategy to avoid prepayment penalties is to make overpayments each year within the allowable annual limit. Most lenders allow you to overpay up to 10% of the mortgage balance each year without incurring an ERC. Some lenders even allow up to a 20% overpayment each year. By taking advantage of this, you can reduce the overall mortgage balance significantly without triggering a prepayment penalty.

Other Fees

Mortgage exit fees, mortgage closure fees and redemption fees are other charges that some lenders apply when you repay your mortgage in full.

• Mortgage Exit Fees

A mortgage exit fee, also known as a "deed release fee" or "administration fee", is charged by your lender when you pay off your mortgage in full. This fee covers the administrative costs of closing your mortgage account and removing the lender’s charge over your property. The mortgage exit fee can vary, but it is usually a fixed amount, often between c. £75 and £300. The lender charges this fee to cover the paperwork and other administrative tasks involved in closing your mortgage. This includes updating the Land Registry records to show that the lender no longer has a claim on your property.

• Mortgage Closure Fees

The term "mortgage closure fee" is sometimes used interchangeably with mortgage exit fee. It refers to the fee you pay to your lender when you fully repay your mortgage, either at the end of the mortgage term or if you repay early. This fee is typically the same as the mortgage exit fee, covering the same administrative processes. The fee is meant to cover the cost of closing the mortgage account, handling the final paperwork and updating the relevant records.

• Redemption Fees

A redemption fee is a broader term that can encompass both the mortgage exit fee and any early repayment charges (ERCs) that may apply if you pay off your mortgage before the agreed term. It is often used specifically to describe the fee charged when you pay off your mortgage early. If this includes an early repayment charge, it might be a percentage of the remaining mortgage balance plus a fixed exit fee.

Conclusion

Prepayment penalties are an important consideration if you are planning to pay off your mortgage early. Exploring options to avoid or minimise prepayment penalties can help you manage your finances more effectively. By reviewing your current mortgage rate terms and using a mortgage penalty calculator, or asking your lender or consulting financial advsior, you should be able to make an informed decision about the cost of early repayment and whether it is the right choice for you.  

FAQs

Q. What is an ERC?

A. An ERC is a fee that lenders sometimes charge if you pay off all or part of your mortgage before the end of your full mortgage term. The ERC is typically a percentage of the loan amount being repaid early above the permitted annual overpayment amount.

Q. When does an ERC apply?

A. Whether or not an ERC applies depends, first, on the type of mortgage rate you are on when your early repayment occurs. For example, if the mortgage rate during your current mortgage rate period is a fixed rate, you will almost invariably be subject to an ERC if your repayment occurs before that fixed rate period ends. On the other hand, if you are on a tracker rate during your current mortgage rate period, you may or may not be subject to an ERC, depending on your lender’s policy with respect to your particular tracker rate. On the other hand, if you are on a standard variable rate or lifetime tracker rate, you will almost certainly not be subject to an ERC.

Q. How much is an ERC?

A. The amount of an ERC varies depending on the lender and the specific terms of your mortgage. Most often, the ERC, if applicable, is calculated as a percentage of the outstanding mortgage balance that you choose to repay over the permitted overpayment amount. For example, suppose you have a £200,000 outstanding mortgage balance, your annual permitted overpayment amount is 10% of the mortgage balance, you are in the first year of a 5-year mortgage rate period, when an ERC rate of 5% applies, and you want to repay your entire mortgage balance. As the annual permitted overpayment amount is 10%, you will pay an ERC on £200,000 minus (£200,000 x 10%) = £180,000. As the ERC rate is 5%, you will pay an ERC of £180,000 x 5% = £9,000.

Q. How can I avoid an ERC?

A. One of the best ways to avoid prepayment penalties is to choose a mortgage rate that does not include an ERC. For example, some short-term variable or tracker mortgage rates do not attract ERCs. If you are not on a rate which avoids ERCs, however, you could consider timing your repayment to coincide with the end of your current mortgage rate period. After this period, many mortgages revert to the lender’s standard variable rate, at which point ERCs typically no longer apply. On the other hand, if you are not in a hurry to repay, but would, nevertheless, like to make significant reductions in your outstanding mortgage balance, a strategy to avoid prepayment penalties is to make overpayments each year within the allowable annual limit. Most lenders allow you to overpay up to 10% of the mortgage balance each year without incurring an ERC. Some lenders even allow up to a 20% overpayment each year. By taking advantage of this, you can reduce the overall mortgage balance significantly, over time, without triggering a prepayment penalty.

Sources:

What is an Early Repayment Charge? | Lloyds