At a Glance

When it comes to different loan types, hidden fees can be disguised in the contract terms. These fees can quickly add up and make the cost of taking on a loan not worth the hassle. This is why identifying any such fees early on is so crucial. A prepayment penalty is one such fee that will sometimes be added to the contract terms and is a fee that can be quite costly.

In this article, you’ll learn:

What is a prepayment penalty?

Paying off a loan early – before the term has ended – feels like a major accomplishment. However, some lenders charge a prepayment penalty, which is a penalty or fine charged when you choose to pay off a loan early. These are also called early payoff fees.

All loans come with a specified term, or the amount of time you have to repay the loan balance. These can range from a few months to several years, and you’ll make monthly payments over the entire term. However, if your lender charges a prepayment penalty, you’ll be forced to pay this fine if you pay off your loan before the term ends.

Not all loans have a prepayment penalty, but if yours does, you can find it in your loan documents. Loans that charge prepayment penalties are typically mortgages, auto loans, and business loans, though some personal loans can also carry this penalty.

How much does a prepayment penalty cost?

The cost of a prepayment penalty depends on the individual lender, though most will either charge:

  • A single, fixed fee
  • A certain percentage of your loan
  • The cost of interest on the remaining loan term

At the end of the day, you may only owe a few hundred dollars or you may be charged a few thousand.

If your loan does have a prepayment penalty, it’s important to understand how the lender charges it and what the total cost would be. This can help you decide if you want to pay off the loan early.

Why do lenders charge prepayment penalties?

Lenders make their money on the interest they charge on loans. When someone pays off their loan ahead of schedule, there’s no more interest accumulating on the loan and the lender will make less money. In this case, a prepayment penalty can help make up for the loss in funds due to the loss in interest earnings.

And, when there’s a penalty, borrowers are less likely to pay off their loan early; therefore, the lender will continue to make more money on interest.

How do you know if your personal loan has a prepayment penalty?

Most of the time, lenders are transparent about the prepayment penalties they charge. In other cases, you may have to dig to find information on their website, or you may need to contact them directly to find out more. Also be sure to always read the fine print in your loan documents about the prepayment penalties prior to signing.

Prepayment penalty personal loan

Prepayment penalties are most common with mortgage loans, though not all mortgage loans will have one. Some personal loan lenders also charge prepayment penalties, especially for loans with higher balances or longer terms. Fortunately, most do not charge a prepayment penalty so you can easily avoid those that do. Understanding the way a prepayment penalty works can help you avoid the fee, though to understand this you must have knowledge of how loan repayment works. There are a few key parts to a personal loan:

  • Principal: A loan principal is the sum being borrowed, which often includes the amount of interest owed.
  • Interest Rate: This is an additional amount of money owed on top of the pure amount borrowed, determined by an agreed upon percentage
  • Repayment Period: The repayment period is the total amount of time a borrower must pay back the loan
  • Repayment Amount: This is the amount owed monthly.

A prepayment penalty occurs when a borrower either pays back the entire personal loan earlier than the total repayment period or pays more than a certain percentage back in a year. In many cases, lenders are more than willing to allow you to make extra payments on a loan but exceeding the set amount will result in a fee.

Prepayment penalty mortgage loan

The general idea of a prepayment penalty on a mortgage loan is the same as a prepayment penalty on a personal loan, however, the purpose can change. Lenders will often add a prepayment loan onto a mortgage loan to safeguard against early refinancing or a home sale in the first couple of years after the purchase.

An early payoff penalty legally needs to be disclosed by a lender before signing, but it’s also a good rule-of-thumb to ask a lender about any existing fee early in the purchasing process. There are two distinct types of prepayment fees regarding mortgage loans:

  • Soft prepayment fee: A soft prepayment fee is when a homeowner is allowed to sell their home without taking a fee, but refinancing the home will be grounds for paying a fee
  • Hard prepayment fee: On the other hand, a hard prepayment fee does not allow a homeowner to sell or refinance without paying the fee

The only type of mortgage loan that does not have a prepayment fee is a Federal Housing Authority loan. It is also worth noting that prepayment penalties on conventional mortgage loans started becoming less common after the housing crisis of 2008, but they do still widely exist today.

Business loans, car loans, and personal loans may all have prepayment penalties associated with them, but it varies lender to lender.

How to avoid prepayment penalties?

The easiest way to avoid a prepayment penalty is to choose a lender who doesn’t charge one. Compare lenders and their loan terms and fees.

If your lender does have a prepayment penalty, you can simply choose to not pay off your loan early to avoid the penalty.

Another option is to try to negotiate with the lender to remove the penalty. The lender may be willing in order to earn or keep your business, so it never hurts to ask.

Make sure to compare the cost of paying off the balance of your loan and the prepayment penalty vs. the cost of continuing to make monthly payments through the term. If you find the prepayment penalty is less than what you still owe in interest, it may be worth it to take the hit. Otherwise, if the penalty is more than what you’ll owe in interest over the rest of the term, you should just continue making monthly payments.

Regardless of the type of loan you seek, always talk with your potential lender about fees and the terms of a loan. It is incredibly important that you understand all the parts of a loan that exist when you sign the contract.

FAQs

You can try! Not all lenders will negotiate, but some may be willing in order to earn or keep your business. They may negotiate the penalty to a lower charge or remove it altogether.

Unfortunately, yes, prepayment can hurt your credit. The two factors that have an impact on your credit score that will be impacted if you pay off your loan early is your credit mix and your prepayment history. Completely paying off a loan can reduce the diversity of your credit, eliminating a type of credit and reducing your overall credit mix. You’ll also have fewer chances to make on-time, in-full payments, and by taking away the ability to build your payment history, your score can decrease.

Under federal law, lenders are not allowed to charge prepayment fees on any educational loans. This has been banned in the U.S. since 1965. Paying off student loans early can be both a profitable and smart idea for anybody who is financially capable. While prepayment penalties on student loans are banned, other loans can have prepayment penalties, so it is important to ask a lender about associated fees.