If you have a mortgage or looked into getting a mortgage in Israel, you likely know that in Israel the banks may charge a fee in the event you pay off the mortgage before the end of the term of the mortgage. Misconceptions abound, and I would like to us this forum to help explain some of the parameters regarding prepayment penalties in Israel.
Is it a Penalty or a Reasonable Fee?
To begin with, the name “prepayment penalty”, when referring to the fee that may be charged by Israeli banks when a mortgage is paid off early, is really a misnomer. It is not a “penalty”, in the sense that you are not being penalized for paying the mortgage off early. When a mortgage is paid off early AND the interest rate at the time of prepayment is LOWER than the interest was at the time that the mortgage was funded, the bank loses money – as they are giving up a higher interest loan and only able to lend out the money at a lower rate. If the interest rates at the time of prepayment are HIGHER than the interest was at the time that the mortgage was funded, there is no penalty. In essence the bank is only recouping losses they incur when allowing the borrower to repay the mortgage early.
To be sure, there are countries where prepayment penalties are prohibited by law. And, this may seem like a fine idea – the borrower wins and the bank loses. But there is a flip side. When establishing rates, the banks are fully aware that the loans will likely be prepaid if rates fall and, therefore, they are forced to increase the initial rates for ALL BORROWERS in order to make up for the anticipated losses. So, in essence, all mortgage borrowers are paying increased rates to mitigate these anticipated losses.
How Are Prepayment Fees Calculated in Israel?
The Bank of Israel regulates how prepayment fees are calculated in Israel. The formula is based on the difference between the interest the bank would earn, until the end of the mortgage term, between the original interest rate (if higher) and the interest rate at the time of prepayment. The banks are required to discount the calculation by the Net Present Value (NPV), which reduces the prepayment fee by discounting the future interest payments to their present value. Furthermore, banks are required to discount the calculation by 20% after 3 years and 50% after 5 years.
Let’s illustrate it with an example. Imagine you take out a NIS 1 million shekel loan for 30 years at a fixed interest rate of 5%. After 3 years, the prevailing interest rate drops to 3%. In such a scenario, the full loss of interest would amount to approximately NIS 347,028. Discounting the loss for NPV would lower the calculation to NIS 237,093 and after the 20% discount, the final calculation would be NIS 189,674. If the prepayment is done after 9 years, the calculation would be NIS 116,873.
Strategies for Mitigating Prepayment Fees
Given the potential impact of prepayment fees on borrowers, it’s prudent to explore strategies that can help mitigate their effect – especially if one believes it is highly likely that the mortgage will be paid off early. One viable approach involves opting for a multi-year adjustable mortgage. With this type of mortgage, the interest rate resets at specific intervals, such as every five years, based on the current market rate at the time of the reset. Consequently, prepayment penalties are calculated only from the prepayment date until the subsequent rate reset.
Returning to our previous example, consider the same NIS 1 million loan with a fixed rate of 5%. If you decide to repay the loan in 3 years, when the rates have dropped to 3%, choosing a multi-year adjustable mortgage would result in a significantly reduced prepayment penalty of NIS 27,886. Similarly, for a loan paid off after 9 years, the penalty would amount to NIS 10,452.
While prepayment fees serve the purpose of safeguarding lenders, they can indeed present challenges for borrowers seeking financial flexibility. Situations such as work-related relocations or personal reasons might necessitate early repayment, leading to an unexpected financial burden. Additionally, shifts in economic conditions or personal circumstances may trigger the need for loan refinancing, potentially activating substantial penalties.
It is crucial to understand how prepayment penalties work, how they may impact you in the future and, if considered significant, to review strategies that may mitigate this impact.