State Mortgage Prepayment Penalty Laws

RE: State Mortgage Prepayment Penalty Laws

You asked what states have banned or limited mortgage prepayment penalties. You would like copies of the relevant laws.

Eleven states generally prohibit prepayment penalties on residential first mortgages. These include Alabama, Alaska, Illinois (if the interest rate is over 8%), Iowa, New Jersey, New Mexico, North Carolina (under $100,000), Pennsylvania (under $50,000), South Carolina (under $100,000), Texas, and Vermont. These states vary in the types of loans they apply this prohibition to. Some cover only single-family homes; others cover multi-family dwellings up to six units. Often there are other conditions, such as that the homes must be owner-occupied, and exemptions for federally insured loans. In addition, Maine prohibits penalties on adjustable rate mortgages, certain high-rate mortgages, and certain consumer contracts, and Maryland prohibits them for nonbank mortgage lenders only.

In 15 states, we found laws that limit prepayment penalties for various types of residential first or second mortgages in some way. Some of these states allow penalties in the early years of a loan and prohibit them after that or limit the penalties to a set percentage of the principal prepaid. These states include: California ( 5 yrs.), Connecticut (3 yrs., 5%), Kansas (6 months), Louisiana (5 yrs., 5%), Massachusetts (3 yrs.), Michigan (3 yrs., 1%) Minnesota (42 months, 2%), Missouri (5 yrs., 2%), Mississippi (5 yrs., 5%), New York (1 yr.), Ohio (5 yrs., 1%) Rhode Island (1 yr., 2%), Virginia (2%), West Virginia (3 yrs., 1% for first, banned for second mortgage lenders), and Wisconsin (5 yrs., 60 days' interest).

Seven states have statutes that limit prepayment penalties only in the sense that lenders cannot charge them unless they are stated in the contract or mortgage note. As long as they meet this requirement, there is no limit on what can be charged. These states include: Delaware, Florida, Georgia, Nebraska, New Hampshire, Oregon, and Tennessee.

Even in the rest of the states, where the statutes are silent about prepayment penalties (and thus presumably allow them without limit), case law or interpretations often require that they cannot be charged unless they are stated in the contract or disclosed in the mortgage note.

We must caution that mortgage prepayment penalty laws are often complex and not always clear. They vary depending on the type of mortgage loan (first or second mortgage, residential, business) and who is making it (different types of state or federally chartered banking institutions or various nonbank first or second mortgage lenders or other types of consumer lenders). In addition, some of these state laws are limited in their effectiveness by federal preemptions described at the end of this report that apply to certain federally chartered financial institutions and certain types of loans (such as adjustable rate residential first mortgages) made by state-chartered and state-licensed lenders.

In Connecticut, for instance, the law is silent on prepayment penalties on residential first mortgages, except for a specific prohibition on prepayment penalties on reverse mortgage loans and graduated payment mortgages. Thus, prepayment penalties are generally a matter of contract, except as affected by federal law. But for residential second mortgages, Connecticut limits prepayment penalties on loans made by nonbank second mortgage licensees (but not banks) to 5% of the balance prepaid and prohibits them after three years. Connecticut statute, like all the states we looked at, is silent about prepayment penalties on business loans.

The most relevant statutes are described below in more detail and copies of the statutes are attached. The last part of this report describes federal laws and regulations relating to the question of federal preemption.

Alabama law appears to prohibit prepayment penalties on some but not all consumer mortgages (Ala. Code § 5-19-3 (f)(2), 5-19-4(c), recently amended by PA 96-576 (S 587). We have enclosed the relevant sections of the existing statute and the new law, but their effect is not entirely clear. Since prepayment penalties are no longer mentioned, but only those charges specifically authorized are allowed, presumably they are still prohibited for this category of loan. The act provides for regulations, which may later clarify this point. National Housing Act approved lenders are exempt from the prohibition, according to an official we spoke to at the Alabama Banking Department. We found no other reference to prepayment penalties in the law.

Alaska law prohibits prepayment penalties on any loan contracts and commitments covering one- to four-family dwellings, except federally insured loans that require a prepayment penalty (AS 45.45.010(g)).

California law prohibits prepayment penalties after five years on one- to four-family residential property and before then allows them only on prepayments that exceed 20% of the original principal amount in any one year, except it allows prepayment penalties for up to seven years on certain loans involving real estate brokers (California Civil Code § 2954.9, California Business and Professions Code § 10242.6). A law passed in 1996 (California Laws Ch. 32, formerly SB 1106), applies the same five-year and 20% limit to certain installment loan features of open-end credit plans that are secured by residential mortgages, effective January 1, 1997.

Connecticut law prohibits second mortgage licensees from imposing prepayment penalties of more than 5% of the balance prepaid and further prohibits any prepayment penalties on prepayments occurring more than three years after the loan date (CGS § 36a-519). It does not limit prepayment penalties on any mortgages made by banks or on any first mortgage loans made by nonbank lenders, except for alternative mortgages (which include graduated payment mortgages and reverse annuity mortgages). A 1973 court case, Dugan v. Grzybowski (332 A. 2d 97 (1973)) decided that without a prepayment clause, a borrower cannot compel a lender to accept prepayment of a mortgage.

Delaware prohibits prepayment penalties unless they are specified in the agreement, but otherwise does not limit them. It specifically allows the borrower to prepay the loan at any time (Del. Code Title 5 § 2234(e)).

Florida law prohibits prepayment penalties that are not specified in the mortgage note. But otherwise it allows them without limit, as long as they are disclosed in the note. The law specifies that any note that is silent with regard to the right to prepay may be paid in full without prepayment penalty (Fla. Stat. Ann. § 697.06, 687.03(3)).

The law prohibits prepayment penalties unless they are stipulated in the contract (Georgia Code Ann. § 7-4-2(b)(2)).

The statute prohibits prepayment penalties or other charges for prepayment on any written mortgage contracts where the interest rate exceeds 8%. The prohibition does not apply to loans insured by federal agencies. The statute also specifies that “interest” does not include prepayment penalties (81 ILCS 205/4(2)(a), 205 ILCS 5-48.2).

Iowa statute prohibits any prepayment penalties on mortgages used to purchase one- to two-family owner-occupied property or agricultural land, and on alternative mortgages. This includes refinancings of these loans. The law does allow a lender to require up to 30 days' advance notice of a borrower's intention to prepay (Iowa Code Ann. § 535.9, 528.4). It also prohibits these penalties on consumer loans (which include second mortgages under $25,000) (Iowa Code Ann. § 527.2501). Prepayment penalties on second mortgages over $25,000 are not prohibited, except on revolving home equity credit lines.

Kansas prohibits prepayment penalties on home loans after six months (Kansas Stat. Ann. § 16-207).

Louisiana statute allows prepayment of any loan as long as it is not prohibited by federal law, but apparently does so by specifically stating that they are not considered interest (La. Civ. Code Ann. Title. 9 § 3505, 3509.3). But a recent law sets graduated limits (from 5% of the principal for the first year down to 1% in the fifth year) on prepayment penalties for simple interest consumer mortgages of $25,000 or more with a term of seven years or more. After the fifth year, the law prohibits prepayment penalties on these loans (La. Rev. Stat. Title 9 § 3532.1 Act 1184 (HB 1853). The law prohibits prepayment penalties on such loans that have a principal of less than $25,000 or a term shorter than seven years.

The Maine law prohibits prepayment penalties on adjustable rate mortgages, except for minimum charges as permitted by law (Maine Rev. Stat. Ann. Title 9A § 9-308). It also prohibits them on certain consumer credit transactions, such as high-rate, high-fee mortgages but apparently allows them for other loans secured by mortgages on real estate (Maine Rev. Stat. Ann Title 9A § 2-401, 2-509, 2-510, Title 9-B § 437).

Maryland law prohibits prepayment penalties only for nonbank mortgage lenders. Otherwise, it allows a borrower, on a loan secured by residential real property, to prepay at any time, unless the contract states otherwise. As long as it is specified in the contract, the penalty in these situations appears not to be limited (Md. Commercial Law § 12-103 (b) (iii), 12-126 (b)).

Massachusetts has a limit on prepayment penalties for first mortgages on one- to three-family owner-occupied property that varies, but only goes up to three years. After three years the law prohibits any penalties (Ch. 183 § 56). There are no limits on prepayment penalties for second mortgages.

The law limits prepayment penalties on single-family units to 1% of the amount of the prepayment for the first three years and prohibits them after that. It exempts federally insured loans from these limits (Mich. Comp. Laws § 438.3(1)(c)).

Under Minnesota law, prepayment penalties are not allowed unless the borrower waives his right to repay without penalty using a uniform written disclosure waiver form. If the borrower waives this right, the lender can charge only up to the lesser of 2% of the unpaid principal balance or 60 days interest on the unpaid principal balance. It nevertheless prohibits prepayments penalties after 42 months. A lender who offers a loan with a prepayment penalty must also offer a loan without a prepayment penalty. The law applies mainly to licensed nonbank mortgage lenders, which are not otherwise regulated, but this statute can apparently also be used by banks (Minn. Stat. Ann. § 47.20(5), as amended Minn. Laws 1995 Ch. 202).

Mississippi statute authorizes prepayment penalties for residential one- to four-family property, but sets certain limits, and prohibits them after the first five years of the loan. The limits are 5% of the unpaid principal balance for the first year, 4% during the second year, 3% during the third year, 2% during the fourth year and 1% during the fifth year (Miss. Code Ann. § 75-17-31(2)). In addition, the law prohibits prepayment penalties in certain situations involving foreclosures, modifications, and refinancings after a declared emergency or disaster (Miss. Code Ann.§ 89-1-317).

Lenders can charge prepayment penalties up to 2% of the balance, but not after five years (Missouri Ann. Stat. § 408.036).

The law prohibits charging of interest in connection with prepayment of a mortgage loan, but allows loan service costs, including prepayment charges, as reasonable and necessary costs without a specific limit (Nebraska Rev. Stat. § 45-101.02)

New Hampshire law specifically allows prepayment at anytime for first and second mortgage loans, subject to whatever prepayment penalty is in the agreement. The law requires only that the prepayment penalty be printed in bold type in the note or in an addendum to it (N.H. Code § 397-A:15, 397-A:16).

New Jersey prohibits prepayment penalties on any mortgage loans on one- to six-family dwellings if the interest on them is over $6 per $100 per year (N.J. Code § 46:10B-1, 10B-2). This applies to banks and nonbank first and second mortgage lenders.

New Mexico prohibits prepayment penalties on home loans (one- to four-family dwellings, mobile homes, and condominiums). The statute makes prepayment penalty provisions in a covered loan unenforceable (NMSA § 56-8-30, 56-8-24). There is apparently one exception for a second mortgage loan used to consolidate debts, which allows prepayment penalties.

Whether or not the borrower has to pay a prepayment penalty depends on the type of loan and whether the lender is state-chartered or federally chartered. Under New York state law and regulations, state banks and state-licensed lenders can impose prepayment fees only under the following circumstances:

1. For fixed-rate mortgages, they can charge a fee only if the loan is repaid within the first year of its term and the contract provides for it.

2. For adjustable rate mortgages, they cannot charge a prepayment penalty at anytime unless the interest rate for the loan does not change for a period of five years and the contract provides for it. For a balloon loan with a five-year term or a 30-year adjustable rate mortgage with five-year adjustment periods, they can only charge a prepayment penalty only during the first year of the loan (N.Y. Gen. Obl. 5-501(3)(b) and 5-501 (7).

North Carolina law prohibits prepayment penalties on home loans secured by first mortgages of $100,000 or less. Otherwise, a lender and borrower may agree on any prepayment terms. But if the loan instrument does not state the borrower's prepayment rights, the borrower can prepay the loan without penalty (N. C. Gen. Stat. § 24-1.1A(b), 24-2.4).

In Ohio, residential mortgage obligations contracted for on or after November 4, 1975 can be prepaid or refinanced without penalty at any time after five years. During the first five years, the prepayment penalty cannot exceed 1% of the original principal amount (Ohio Rev. Code Ann. § 1343.011). Second mortgage lenders can charge prepayment penalties of up to 1% of the original loan amount (Ohio Rev. Code § 1321.57). But if the lender charged points or prepayment penalties within one year of a refinance loan, new points and prepayment fees cannot be charged again.

The statute permits prepayment penalties but requires disclosure in the loan agreement (Oregon Rev. Stat. § 86.150, 708.480, 82.160).

Pennsylvania has a statute prohibiting prepayment penalties on residential mortgage loans (apparently only those under $50,000 on one- to two-family property) (41 P.S. § 101, 405) and another statute prohibiting them altogether on loans made by second mortgage licensees (7 P.S. 6612). But these are at least partially preempted by the federal laws for federal savings and loan associations, first mortgages, and federally defined alternative mortgage loans (adjustable rate mortgages), according to Valento DiGiorgio, an attorney with the Pennsylvania Banking Department.

Rhode Island law prohibits prepayment penalties on mortgages on one- to four-family dwellings after the first year. During the first year, it allows a maximum prepayment penalty of 2% (R.I. Gen. Laws § 34-23-5). This applies regardless of who makes the loan and covers both first and second mortgages.

South Carolina law prohibits prepayment penalties for first or junior mortgage loans of $100,000 or less (S.C. Code Ann. § 37-10-103(1)).

Prepayment penalties are governed by contract, except as limited by express statutory provisions (Tennessee Code Ann. § 47-14-108).

On loans secured by one- to four-family dwellings, no prepayment penalty or charge may be collected, except where such collection is required by a federal agency (Texas Rev. Civ. Stat. Ann. Art. 5069-1.07(a) and (d)(4)).

Vermont law prohibits prepayment penalties on loans, with certain exceptions (Vermont Stat. Ann. Title 9 § 45). The exceptions include obligations of corporations, including municipal and nonprofit corporations, business loans, agricultural loans, second homes for seasonal or part-time occupancy, and federally guaranteed loans (Vermont Stat. Ann. Title 9 § 46).

The law limits prepayment penalties on owner-occupied homes to 2% of the amount of the prepayment and prohibits them on one- to four-family residential dwellings if prepayment results from enforcement of the lender's right to call the loan upon sale of the property. Otherwise, every contract, except an installment sales contract, for a first mortgage on real estate of less than $75,000 may permit prepayment at any time with a prepayment penalty of no more than 1% of the unpaid balance (Virginia Code § 6.1-330.81, 330.83, 330.87).

Prepayment penalties on first mortgage loans and bank loans are allowed up to 1% for the first three years of a loan only. In no event can a prepayment penalty be charged on a refinancing within one year of the prior loan. The law also prohibits any prepayment penalties for second mortgage licensees or industrial loan company licensees (now known as regulated consumer licensees). It exempts housing loans originated by the West Virginia Housing Development Fund from its restrictions (W. Va. Code § 46A-3-110, as amended by Ch. 71, 1996).

Wisconsin law allows a lender, on a one- to four-family first mortgage, to charge a penalty equal to 60 days' interest for the first five years, but prohibits it after that (Wisconsin Stat. Ann. § 138.052).

Federal law preempts state interest limits on virtually all residential first (but not second) mortgage loans, regardless of who makes them. The law covers “federally related” first mortgage loans made after March 31, 1980 if they are made by lenders whose deposits are federally insured (all banks and credit unions in Connecticut); loans that are federally insured or made in connection with a Housing and Urban Development (HUD) housing or urban development program; loans that are eligible for purchase by the Federal National Mortgage Association, Government National Mortgage Association, or Federal Home Loan Mortgage Corporation; or loans made by other creditors who make or invest in residential real estate loans totaling more than $1 million per year or by any lenders approved for federal insurance programs (12 U.S.C.A. § 1735f-7a(a), 1735f-5). In effect, the preemption covers nearly all first mortgages. For the interest preemption, there was a short window period between 1980 and 1983 when states could override the federal preemption by passing legislation or a constitutional provision explicitly stating that they do not want the provision to apply to loans in its state (12 U.S.C.A. § 1735f-7a(b)). Only 15 states took this action; Connecticut was not one of them, since it has traditionally had no interest limits on mortgage loans over $5,000. The states that overrode the preemption in some fashion include Colorado, Georgia, Hawaii, Idaho, Iowa, Kansas, Maine, Massachusetts, Minnesota, Nebraska, Nevada, North Carolina, South Carolina, South Dakota, and Wisconsin.

But even though states that did not override the actual interest preemption in the window period are now precluded from doing so, the same federal law does allow a state, anytime after March 31, 1980, to adopt a law placing limitations on “discount points or such other charges” on the first mortgages described in the federal law (12 U.S.C.A. § 1735f-7a(b)(4)). Prepayment penalties appear to fit under these other charges, but the state laws would still be subject to the specific federal preemptions described below.

Office of Thrift Supervision regulations issued under the federal law preempting interest limits on first mortgages state that “Nothing in this section preempts limitations in state laws on prepayment charges, attorneys fees, late charges, or other provisions designed to protect borrowers” (12 C.F.R.§ 590.3 (c)). The next section prohibits prepayment penalties specifically on residential mobile home mortgages by stating, “A debtor may prepay in full or in part the unpaid balance of the loan at any time without penalty. The right to prepay shall be disclosed in the loan contract in type larger than that used for the body of the document” (12 C.F.R. § 590.4(d)).

Another section of these regulations, which only applies to federal savings banks and savings and loan associations, allows imposition of a fee for prepayment of a real estate loan, subject to the terms of the loan contract (12 C.F.R. 560.34, 61 FR p. 50971 etc.). This preempts state laws, but only for these specific federal institutions.

Office of the Comptroller of the Currency regulations (61 FR p. 11,294, 11,301 (March 20, 1996) to be codified at 12 C.F.R. § 34.20 TO 34.25) override state restrictions on adjustable rate mortgage loans (including restrictions on prepayment penalties) made to finance or refinance the purchase of, and secured by a lien on, a one- to four-family dwelling. This override applies to both national banks and state-chartered commercial banks, so these institutions can charge prepayment penalties on such loans regardless of any state bans or limits on their adjustable-rate first mortgages. There appears to be no preemption on prepayment penalties for fixed-rate mortgages made by national banks or state banks located in a state.

Federal Reserve Board truth-in-lending regulations, which cover all loans to consumers, set special requirements for home equity loans whose interest rates or points exceed certain levels. The rules apply in situations where either (1) the annual percentage rate is more than 10 percentage points above the yield on U.S. Treasury securities with maturities comparable to the loan's maturity as of the 15th day of the month immediately preceding the month when the lender receives the application or (2) the total points and fees the consumer must pay by loan closing is more than the greater of 8% of the total loan amount or $400 (the $400 figure is adjusted annually on January 1 by the annual percentage change in the Consumer Price Index that was reported on the preceding June 1) (12 C.F.R. § 226.32). For loans that fit into this category, the lender must make extra disclosures to the consumer and cannot charge a prepayment penalty, except as otherwise permitted by law and only if (1) the penalty applies only during the first five years of the loan, (2) the source of the prepayment funds is not a refinancing by the lender or the lender's affiliate, and (3) at the closing, the consumer's total monthly debts (including amounts owed under the mortgage) do not exceed 50% of his monthly gross income, as verified by his signed financial statement, a credit report, and employment income records.