Common Lender Pre-payment Fee Miscalculation

It's amazing to me how some lenders will enforce loan terms that are not a part of the loan agreement or note. Worse than that, many borrowers are unaware that the lender is cheating them. A common example occurs when lenders miscalculate pre-payment penalties at the borrowers' expense.

So what's the problem? The problem is a lack of understanding of simple algebra. Here's an example: Let's say you have a mortgage of $100,000 and you want to pay down the balance (principal reduction) by mailing a $20,000 check. However, you must also pay a 3% pre-payment penalty according to your loan agreement. Many lenders will unjustifiably demand that you owe them a pre-payment penalty of $600. It sounds right because 3% of $20,000 is $600, but it is completely wrong.

The correct way to calculate a pre-payment penalty is to first realize that the pre-payment penalty is included in the $20,000 check and the rest of the $20,000 will go towards paying down the loan. The portion of the $20,000 that is the pre-payment penalty must not be used in calculating the pre-payment penalty itself. Otherwise, you're being penalized for paying a penalty.

The equation is as follows:

Pre-payment penalty + Principal Reduction = Check you're mailing

In mathematical terms, that;s:

Principal Reduction x(pre-payment penalty rate/100) + Principal Reduction = Check you're mailing

Substituting the numbers from our example:

Principal Reduction x (3/100) + Principal Reduction = $20,000

Simplifying:

.03 x Principal Reduction + Principal Reduction = $20,000

Simplifying further:

1.03 x Principal Reduction = $20,000

Now, solving for “Principal Reduction”, we get:

Principal Reduction = $20,000/1.03

Which is:

Principal Reduction = $19,417.47

Which is rounded down to the nearest penny in favor of the lender. This means that the pre-payment penalty is $582.53 ($20,000 - $19,417.47). Originally, the lender was demanding $600, which is $17.47 too much.

To keep it easy, the equation is:

Principal Reduction = Check you're mailing/(1 + (pre-payment penalty rate/100))

Sometimes this is hard to explain to someone in a bank, but there is a clever way around having to teach a bank employee basic algebra. Try simply writing two separate checks and on the memo portion of one check write “principal reduction”, and on the other write “pre-payment penalty”. Include a letter explaining that you want to pay down your loan by $19,417.47 and that you've already calculated the pre-payment penalty for them.

They'll understand this, won't question you, and you'll save $17.47 every time you do this! Of course, with larger loans or higher pre-payment penalties, you'll save even more. I hope this helps!