Early repayment penalty: 5 questions on selling a house before the fixed-interest period expires

Early repayment penalty: Definition

A common question home sellers ask is: what is a prepayment penalty? This is a fee that can be charged by the lender if the borrower decides to terminate the jointly concluded contract early. The early repayment penalty is regulated by law in § 502 of the German Civil Code. This states that the lender may demand reasonable compensation from the borrower in the event of early repayment of the loan within the agreed fixed interest period. Thus, the bank does not necessarily have to charge the borrower an early repayment fee. In practice, however, it turns out that it is part of the rule.

Why do you pay the early repayment penalty?

Another question that arises when selling a house before the fixed-interest period expires is the purpose of the prepayment penalty. After all, the loan will be repaid to the bank even if the contract is terminated.

The reason why banks charge early repayment penalties is that paying off the debt early results in an interest loss. After all, the credit institution has paid interest on the loan for years, sometimes decades, and has calculated with this constant income. To compensate for this damage, the borrower incurs the additional costs in the form of the compensation in addition to the actual loan.

How do you calculate the early repayment penalty?

There is no legal requirement as to how high the early repayment penalty should be. There is also no uniform regulation that the bank must follow. The exact amount of the additional costs that become due in the event of early termination of the loan agreement is calculated individually by the bank. There are basically two methods available to the bank for this purpose, the so-called asset-asset method and the asset-liability method.

The asset-liability method

If the bank calculates the early repayment fee according to the asset-liability method, it assumes that it can lend the prematurely repaid loan to a new borrower. The amount of the compensation essentially depends on two factors: Firstly, it is based on the damage caused by the so-called interest rate difference. The interest rate differential (also called interest rate deterioration loss) is a financial loss for the bank that arises because the institution can only lend the prematurely repaid loan again at a lower interest rate than was stipulated in the original contract. The second determining factor for the asset-liability method is the interest margin loss. This loss arises from the loss of profit that the bank has calculated for the term of the loan. Put simply, the remaining term determines the amount of the interest margin loss.

The asset-liability method is often the more favourable of the two alternatives for the borrower, which is why it is not usually used by the bank.

The asset-liability method

The asset-liability method is the most common way for banks to calculate the early repayment penalty. Here the bank assumes that it will invest the repaid loan on the capital market in the form of mortgage bonds. With this method, too, two factors are decisive. Firstly, the bank calculates the expected return that the investment will achieve on the capital market for the same term. Secondly, the bank calculates what profit it would have received from the contractual interest rate if the loan had been repaid as originally agreed. The difference between these two sums results in the early repayment fee. In order to prevent the bank from investing the loan in an investment that intentionally offers low interest rates (which would consequently increase the difference and thus the early repayment penalty), only mortgage Pfandbriefe are permitted by law as an investment.

Nevertheless, the asset-liability method is in most cases the more profitable one for the credit institution, which is why it is preferred when calculating the early repayment penalty.

Avoiding the early repayment penalty: How does it work?

For most property owners, the additional costs incurred when selling a house before the fixed interest rate expires represent an undesirable financial burden. Consequently, the question arises of how to avoid the early repayment penalty. In fact, some exceptional cases exist in which it is possible to repay the loan early without having to pay compensation to the bank.

Exception 1: Cancel the loan after 10 years

One way to avoid the early repayment penalty is to terminate the loan agreement after 10 years. By law, every borrower (and only the borrower, not the credit institution) is allowed to terminate the loan contract after 10 years with a notice period of 6 months. Afterwards, only the required balance of the loan and the interest must be paid on the due date. The borrower, on the other hand, is spared the early repayment penalty.

Exception 2: Repayment by insurance or building society contract

Another way to avoid the early repayment penalty is to pay the repayment from the funds of an insurance policy taken out for this purpose. Such an insurance policy is taken out as part of the loan agreement and must accordingly have been agreed by both parties beforehand.

Exception 3: Insufficient information

Another exception, which extinguishes the right to an early repayment penalty, is based on insufficient information in the loan agreement. If the credit institution fails to provide precise information on the contract term, the borrower's right of termination or the calculation of the early repayment penalty, the lender loses its claim to the compensation.

In reality, however, a lapse of the early repayment penalty due to insufficient information or a repayment by insurance as described in exception 2 is extremely rare. Practice shows that borrowers usually have to expect the additional fee.

In addition to these legally guaranteed exceptions, some credit institutions have defined some hardship cases in which no early repayment penalty is due either. These three hardship cases usually refer to unemployment, death or disability:

Early repayment penalty for unemployment

If one of the borrowers and main earners of the loan has been registered as unemployed for a longer period of time (often more than 6 months) and is still continuously unemployed, some banks waive the early repayment penalty for immediate repayment. Depending on the funds used to repay the loan, a house sale may not be necessary. This is the case, for example, if the borrower repays the amount from his own funds.

Prepayment penalty in the event of death

In the meantime, some credit institutions waive the prepayment penalty if the loan is repaid immediately as a result of the death of one of the borrowers. Here, too, it is not always necessary to sell the property: Provided the loan can be repaid with the borrower's own funds (for example, the deceased's life insurance policy), no sale is necessary.

Early repayment penalty in the event of disability

Some credit institutions now also waive their right to an early repayment penalty if a borrower is unable to work. If the borrower has become unable to work (not incapacitated!) in the past 12 months and the loan can be financed from his or her own funds, no sale of the property is necessary in this case either.

Early repayment penalty also for KfW loans?

Property owners sometimes ask whether an early repayment penalty is also due if the loan was taken out through the Kreditanstalt für Wiederaufbau (KfW). Since the Kreditanstalt für Wiederaufbau is a public law institution, some home sellers assume that the rules are different in the case of a house sale before the fixed interest period expires. In fact, however, Kreditanstalt für Wiederaufbau can charge an early repayment fee just like any other private bank.