Prepayment Penalty

Prepayment penalty summary: 

• Some lenders charge an extra fee called a prepayment penalty. 

• A prepayment penalty is a fee for paying off a loan ahead of schedule. This fee partially compensates lenders for the interest you won’t pay on the loan because you paid it off early.

• It’s possible to avoid prepayment penalties. Talk to the lender before you finalize a loan.

Prepayment Penalty Definition and Meaning

A prepayment penalty is a fee that some lenders charge for paying off a loan ahead of schedule. Not all types of loans allow for prepayment penalties, and not all lenders charge them. 

Ask the lender if your loan has a prepayment penalty, especially if you’re thinking of paying the loan off early.

You might think that lenders would want to get paid faster, right? Actually, lenders might lose money when you pay off a debt too quickly. If you pay off installment loans ahead of schedule, your creditors don’t earn the full amount of interest that they were planning to get from you. Some lenders make up for part of this lost income by charging a prepayment penalty. 

Prepayment Penalty: A Comprehensive Breakdown  

Here’s a breakdown of what to watch for and where you might see a prepayment penalty.  

Mortgage loans

Prepayment penalties are most often found in mortgage loans. A typical mortgage prepayment penalty might be 1% or 2% of the remaining mortgage balance—but only if you pay off the balance during the first three years of the repayment period. 

If you want to pay off your mortgage early, calculate the interest charges you’ll pay until the prepayment penalty expires, and compare that amount to the prepayment penalty fee you’ll pay.

Auto loans

Some auto loans also charge a prepayment penalty. But this depends on your state; some states have laws that prohibit auto loan prepayment penalties. 

Upfront disclosure

Lenders must tell you about any prepayment penalty before you sign a contract for a new mortgage or other loan. The prepayment penalty should be explained in your loan documents. Before you agree to take out a loan, read your contract carefully and ask about the prepayment penalty. 

Negotiate

If you don’t want a prepayment penalty attached to your loan, ask your lender to remove that language from the loan agreement. Some lenders might agree to delete the prepayment penalty from the contract. 

Prepayment penalties are becoming more rare

Not every loan has a prepayment penalty. Student loan lenders are not allowed to charge prepayment penalties, and many personal loans do not use them. Credit card debt doesn’t have prepayment penalties, either; you’re free to pay off your credit card balance as fast as you can. 

And even for home mortgages, prepayment penalties have become less common over time.  

Types of Prepayment Penalty

There are a few types of prepayment penalty, and the exact details will depend on the fine print in your loan documents: 

• Hard prepayment penalty: This is a strict type of prepayment penalty, where you have to pay an extra fee if you refinance or even sell the house at any time.

• Soft prepayment penalty: This is a more forgiving type of prepayment penalty. It allows you to sell your house (and pay off your mortgage early) without getting charged an extra fee.

• Time limits: Some prepayment penalties have time limits, and only charge you a fee if you pay off extra principal, sell, or refinance within a certain number of years of taking out your mortgage.