HELOC prepayment penalties: Understanding the costs

U.S. homeowners are now holding more home equity than ever before, reaching more than $32 trillion according to the latest data from the St. Louis Federal Reserve. Alongside this historic rise, there has been an increase in the popularity of home equity lines of credit (HELOCs). These revolving lines of credit allow homeowners to borrow against the value of their homes for various purposes, such as home improvements, debt consolidation, and emergency expenses.

While paying off your HELOC balance early may seem a wise financial move, many borrowers are shocked to learn that their lenders impose prepayment penalties for doing so. These fees can even add up to thousands of dollars, significantly impacting the overall cost of a HELOC.

Read on to understand what prepayment penalties are, how they work, and how you can avoid them.

What you’ll learn

• What is a HELOC prepayment penalty?
• Why lenders charge prepayment penalties
• Types of HELOC prepayment penalties
• Calculating the cost of prepayment penalties
• Avoiding or minimizing prepayment penalties

What is a HELOC prepayment penalty?

A HELOC prepayment penalty is a fee imposed by lenders when a borrower decides to pay off their HELOC earlier than agreed upon, typically within a certain period after the loan is originated. These penalties are designed to compensate lenders for the interest income they lose out on when a loan is paid off ahead of schedule.

In the context of a HELOC, prepayment penalties can apply in various situations, such as when you refinance your loan, sell your home or close the line of credit before a predetermined time frame. The specific terms of these penalties can vary, ranging from a percentage of the outstanding balance to a flat fee. In some cases, lenders may also require repayment of any closing costs that were initially waived when the HELOC was opened.

Why lenders charge prepayment penalties

Lenders impose prepayment penalties on HELOCs as a way to secure their expected earnings from the interest that would have accrued over the life of the loan. When a borrower pays off their HELOC early, the lender loses out on this potential income, so the penalty acts as compensation for that loss.

Prepayment penalties also help mitigate the risk that comes with fluctuating market conditions, where borrowers might otherwise pay off their loans quickly to take advantage of better financial opportunities. By imposing a penalty, lenders can both discourage early payoffs and protect their profits.

It should be noted that not all HELOCs come with the same penalties and fees. For example, Alliant's HELOCs do not have a prepayment penalty. This is something to consider when shopping around for a HELOC, as these potential fees could impact your overall borrowing costs.

Types of HELOC prepayment penalties

HELOC prepayment penalties can take several forms, depending on the lender’s policies and your loan agreement’s specific terms. One common type of penalty is the early closure penalty, which applies when you close your HELOC within a few years of opening it. This fee can be a flat amount or a percentage of the remaining balance, potentially costing you hundreds or even thousands of dollars.

Another form of prepayment penalty involves the recapture of waived fees. When you first open a HELOC, lenders often cover certain closing costs, such as appraisal fees or title search fees, to make the loan more attractive. However, if you pay off your HELOC early, the lender may require you to repay these previously waived costs, adding to your overall expenses.

Finally, some lenders impose interest penalties on the unpaid balance of your HELOC. This means that even if you pay off the principal early, you may still be required to pay a portion of the interest that would have accrued over the original term of the loan.

Calculating the cost of prepayment penalties

The cost of prepayment penalties on a HELOC is calculated based on several factors, including the outstanding balance, the penalty rate, and any waived fees that might be recaptured. For example, if your lender charges a 2% prepayment penalty on a $40,000 outstanding balance, you would be required to pay $800 as a penalty.

Let's consider a more detailed hypothetical scenario. Imagine you took out a $75,000 HELOC and used $50,000 for various expenses. If you decide to sell your home and pay off the HELOC after just two years, with a 3% prepayment penalty, you would incur a $1,500 fee. If the lender also recaptures $600 in previously waived fees, the total penalty would rise to $2,100.

Avoiding or minimizing prepayment penalties

One of the best ways to avoid or minimize prepayment penalties on your HELOC is by negotiating the loan terms before you commit. Lenders often have some flexibility, and if you have strong credit, you might be able to secure a deal with reduced or even no prepayment penalties. Make sure this conversation happens before you finalize the loan to eliminate any surprises later.

Strategically timing your prepayment is another method to help reduce any penalties. HELOCs often have a window during which prepayment penalties apply, typically the first few years after opening the line of credit. By planning to pay off your balance after this period ends, you can avoid these charges entirely.