Prepayment Penalty: The Basics
Definition & Money Saving Tips
A prepayment penalty is a fee charged by your lender when you pay off a loan “early.” Loans like auto loans and home loans generally have a term (for example, 5 year auto loans or 30 year mortgages). If you pay off the loan quickly, you might have to pay extra charges.
How Much are Prepayment Penalties?
Prepayment penalties are often calculated in one of several ways.
Percentage of loan balance: some lenders charge you a percentage of your outstanding loan.
For example, if you owe $100,000 and the penalty is 2%, you’d pay a $2,000 prepayment penalty.
Interest costs: other loans charge penalties based on how much interest the lender was going to earn if you kept the loan for the entire term. Calculations vary by lender, and are often based on a number of months’ worth of interest.
Flat fees: some lenders keep it simple. For example, Wells Fargo charges $500 if you prepay certain home equity lines of credit (HELOCs) within three years.
Dodging the Fees
How can you avoid prepayment penalties? Waiting to pay is the easy answer, but you might not want to let your loan run for decades.
Depending on your loan, you might be able to prepay a portion of your loan every year without facing penalties. For example, some lenders allow you to pay up to 20% of your balance annually without any prepayment penalty.
Penalties can also change over time (they might decrease or disappear completely after several years), so make sure you know how your loan works before you prepay; it might pay to wait.
After the 2008 mortgage crisis, the Dodd-Frank Act limited prepayment penalties on mortgages. For home loans issued after January 10, 2014, lenders can only impose prepayment penalties for the first three years of your loan (and the maximum penalty is 2%). If you’re borrowing to buy a house, verify whether or not there is any prepayment penalty, and see if your loan falls under these rules – most loans do.
Lenders are required to provide consumers with clear information explaining the prepayment penalty (so this information should be easy to find, but some lenders might be less helpful than others).
For other types of loans, you’ll really need to read your agreements carefully. Prepayment penalties are still found on auto loans and business loans. On personal loans, they’re less likely, but you always need to read the find print.
Why Lenders Charge Fees
Why can’t we just live in a world without prepayment penalties? As you might imagine, lenders don’t always like it when you pay off debts early. Lenders planned to earn a profit from your loan, and you’re taking your ball and going home. As a result, they’re going to get that revenue one way or another.
Although it’s not always the case, it might even make sense to choose a loan with a prepayment penalty (assuming you’re confident that you won’t pay early). When you do so, you reduce the risk that your lender takes, and that might encourage them to reduce your costs in return. However, this only works out if you have options – if you can compare the terms of loans with and without prepayment penalties and choose the best one.