Lock-in Clause

Definition of "Lock-in clause"

Written by

Sarah Strobel

Charles Rutenberg Realty

The term lock-in clause is used in an agreement that prescribes a period of time within which either of the parties that signed a contract cannot terminate the contract. In case one of the parties within the contract terminates the contract before the period specified runs out, this clause is enforced. The lock-in clause is enacted, claiming the party in breach to pay for the cost of the remaining period in the contract, part of it and/or additional fees. This payment is required even though the party breaching the contract will no longer benefit from the service.

In other words, a lock-in clause is used as a debt instrument that restricts an early termination of the contract. If this happens, the party that terminated the contract must pay the remaining amount of service in total, usually in one lump-sum payment.

What is Specified in a Lock-in Clause?

There are three main things that are specified in the lock-in clause. Firstly, we have the duration of the lock-in period, which is the time during which terminating the contract is restricted and will incur the payments and, in some cases, even extra fees. Secondly, we have the remedy in case of breach of the lock-in commitment, where it is specified what the party that terminates an agreement early can be forced to pay. Thirdly, we have the notice period required for early termination so that the other party can find a suitable alternative for their service. This notice can vary but, for instance, if the notice period is ¾ months in the agreement, then, once the notice of termination is completed, the party that ends the agreement has to pay the following 3 months after the notice, even if they no longer benefit from the service.

To better understand these clauses, we could look at what happened in Europe with telecommunication companies. For years, these companies used these lock-in clauses to literally lock their clients in these contracts that were standard for two years, but if someone wanted to terminate their subscription before the contractual period was over, they had to pay for the remaining months of the contract and extra fees. A few years ago, however, due to multiple lawsuits, this clause was taken out of those contracts as it was unreasonable. The same can happen if the notice period is too long. Some of these clauses in the US can not legally be enforced due to the fact that they are unreasonable.

Examples of Lock-In Clauses in Real Estate?

While these clauses can be applied in most time-limited contracts that provide services, the real estate industry applies them in many instances. As the term relates to a period of time for a contract or agreement, loans and mortgages are also for a period of time, and if you want to end a loan or mortgage earlier than agreed, you can be affected by these lock-in clauses.

Terminating a loan, however, can happen not only because you default on a loan. You could also pay off the loan in full, sell the property or refinance your loan. Having to pay extra fees for any of these situations may come as a surprise. For instance, if you are forced to sell the property after just one year because you need money fast, a year isn’t enough for the property to appreciate, increase in value and cover both loan and interest, not to mention the penalty fee. Make sure to check the terms and conditions in your contract as this period is specified, but while it's typically around two to five years, they can vary between types of loans and lenders.

When it comes to penalty fees, similar to the duration of the lock-in period, they can vary, but most are between 2% and 5% of the outstanding loan amount. And just to give an example, if you buy a property for $510,000 and decide to sell it a year later. After one year, the outstanding loan amount should be $500,000, and based on the percentages mentioned above, you could have to pay an additional $10,000 if it’s 2% or $25,000 if the rate is 5%.

Reading the fine print is important with any type of contract, but even more so with mortgages and loans, as these loans are for large sums of money. It’s always best to discuss these things with a real estate agent or real estate lawyer to make sure you don’t sing something you’ll end up regretting. And always, try to borrow as much as you can repay, especially with fluctuating interest rates and inflation.