It costs a lender money to make a loan, which it expects to recoup through interest collected during the term of the loan. But if a borrower pays off a loan within a short time of obtaining it (generally under two years), the lender has not had time to recoup its lending costs. To protect the lender against a quick payoff, prepayment penalties may be owed. The prepayment penalties are spelled out in the mortgage note at the time of obtaining the mortgage. From the borrower’s perspective, the tax law looks favorably on prepayment penalties, allowing them to be deductible if certain conditions are met.
If you pay off your mortgage or home equity debt before you are required to, there may be a prepayment penalty as specified in your mortgage papers. Prepayment penalties are treated as deductible interest-they are a set amount of interest-for example, six months of interest on 80 percent of your outstanding loan balance) if you pay off the mortgage before a set term (usually one to two years).