Except the loan was paid including all interest for the lifetime of the loan. If you prepaid your mortgage that way, even on purpose, your bank would owe you a good portion of your money back.
I think gp meant prepayment including all future interest, which would more than cover prepayment fees.
High-lvl: prepayment fees is roughly equal to interest owed minus alternative interest options the bank has (eg someone else’s mortgage). Disclaimer: Dutch perspective.
It's a bit complicated financially and the details vary based on fixed vs variable terms but I'll try to offer a simplified example of why pre-payment penalties exist.
Imagine I go to a bank today and take out a $100,000 mortgage on my house at a fixed rate of 2% (yeah - that's 2020) on a 5-year term[0] with a 25-year amortization.
The bank gives me that $100,000 cash today on the expectation that they will get it back with 5 years of interest (calculation is a bit complex but should work out to just over $9k over the 5 years).
We could keep it simple and say that once you've agreed to pay a bank $9k in profit, they are in the business of making sure they get that profit. Repaying any amount of the debt ahead of schedule does not exempt you from paying that anticipated profit.
In the banks' defence, the details are a little more complicated in practice. Banks rarely lend out their own money. When I take out this mortgage, the bank just issues a $100,000 bond to an investor. The bank presumably guarantees the bond so the risk to the investor is less than the mortgage itself and, so, the bond has a lower interest rate - say 0.5%. The difference in interest rates is the actual profit to the bank.
Bonds have a couple characteristics:
a) they are fixed-term (in this case, 5 years); and
b) payout of both interest and principal is guaranteed (by the bank)
So if you decide to pay back your mortgage (or some amount) ahead of schedule, the bank still has to pay out their bond commitments and that money needs to come from somewhere. And the bank isn't gonna front it. Depending on markets and current interest rates, the bank may be able to re-use that bond on someone else's mortgage so your penalty may be reduced in some cases.
[0] These shorter-than-amortization terms are a thing here in Canada. Not sure if it works the same in other countries.
In the UK we commonly have 2 to 5 year fixed interest rates on a 25 year mortgage, with the remaining years at a variable base rate + X%.
I think this achieves a similar result, as anyone who leaves their mortgage unchanged beyond the fixed rate period almost always ends up on a punitive rate.
As I understand it, the logic is the bank is expecting to make a good deal of money over the life of the loan in interest. Prepaying reduces that profit, so they penalize you to discourage that behavior. Note that not all mortgages have that penalty (mine doesn't).
As with most financial things it depends on location and time and specific conditions.
Generally, its been illegal since 2014 nationwide to have a prepay penalty. In my state its been illegal as long as I've had a mortgage. In some weird but possible conditions its possible post-2014 to have a prepayment fee at the national level for a normal residential mortgage.
You'll see all kinds of random dates at the national level. From what I understand the 2010 Dodd-Frank act was the enabling legislation, the new rules came out in 2013, and went into effect in early 2014, but its all the same issue.
While it may not be an explicit penalty at time of prepayment, the risk of losing revenue due to prepayment/refinancing if interest rates drop is definitely modeled priced into the terms of the loan, just as the risk of you going bankrupt and not being able to pay is.
I don’t think you understand how banks earn money. People deposit funds which they then loan to others. The interest they get from the debtors is more then the interest they pay depositors. If everyone repaid their mortgage early they have no profit, so they need to cover themselves for that. They aren’t charities.
And the bank does get the interest, for the duration for which the money is not in their hands. A "pre-payment penalty" sounds to me like the bank asking you for money while they themselves can then also turn around and loan that (now repaid, with penalty!) money out to another person desiring a loan, and get even more profit.
> The interest they get from the debtors is more then the interest they pay depositors.
The interest paid to most accounts these days is a pittance, adding less back than is lost to inflation, and many accounts have additional fees.
If you have GOOD mortgage terms, (1) any prepayment should go to PRINCIPAL and (2)there should be NO prepayment penalty.
(1)is sacred. If you don’t have (1), you are a noob.
(2)is sometimes bargained away to get a lower interest rate, often, in the form of lower points. Once again, if you have a prepayment penalty without a demonstratable financial consideration, you are a noob.
Don’t be offended, we are all noobs at one time or another. Banks are not educational institutions. Indeed, universities themselves are quite unforthcoming about the opportunity costs and ROI of their own products.
I don't believe it's all that common. Most mortgages can't even have prepayment penalties, or can only have them during the first few years of the contract.
You must have a very old loan or not be in the US, because prepayment penalties aren't legal anymore on US residential loans. Also, what I mean was paying all the interest for the lifetime of the loan. That would be significantly more than the principal balance and prepayment penalty.
That is highly specific to your own agreement, and such penalties are usually only for the first 3-5 years. For myself, I have always negotiated 0 prepayment penalties.
Interest accrues on a monthly basis, so if you pay it off now you won't accrue the interest on an ongoing basis.
In other words - over the life of the loan/mortgage you will pay $X in principal and $Y in interest. If you suddenly pay the whole thing back, then $Y becomes much smaller. So if you paid $X + $Y in a lump sum then you would receive some money back, is what they are saying. Because you have overpaid on the interest, because that interest never accrued.
(not sure whether in this case Citibank paid the full sum of the principal or expected interest or not, but yes, if you did that on your mortgage then you would be entitled to receive some money back)
If you calculate all the money you will put into your mortgage loan over time, add it all up, and write a check for that amount, it will be more that your principal balance because of interest.
I think op is implying the difference in non-accrued interest. IE your payment at that point would be all principle, thus negating the loan and incurring over payment.
