Prepayment Penalties: The Basics
Definition & Money-Saving Tips
A prepayment penalty is a fee that lenders can charge when you pay your loan off early. Some loans, such as 30-year mortgages or four-year auto loans, have an expected payoff date. If you pay off the debt before then and your loan has a prepayment penalty clause, you may have to pay an additional fee.
Learn how prepayment penalties work so you can decide whether or not it makes sense to use a loan with a prepayment penalty. You’ll understand why lenders use these fees, what the charges typically look like, and how you can avoid paying prepayment penalties.
What Is a Prepayment Penalty?
A prepayment penalty is a fee that lenders may charge when you pay off part or all of your loan balance before the loan’s scheduled maturity date. Loans like car notes and mortgages are often designed to last for a specific length of time (known as the “term”), with the loan balance reaching zero at the end of the term. If you pay off the debt early, lenders can potentially charge penalty fees for that prepayment.
Why Do Lenders Charge Prepayment Penalties?
A prepayment penalty discourages borrowers from paying off loans quickly. When lenders issue loans, they expect to earn interest income over time. But when you pay down your loan balance faster than expected, lenders earn less interest, causing reduced profits on your loan. With a prepayment penalty, lenders can either receive some of the money they expected or incentivize you to stretch out your payments.
Types of Loans With Prepayment Penalties
Some home loans feature prepayment penalties. However, there are no prepayment penalties on single-family FHA loans, and penalties on other loans are limited. For most home loans issued after January 10, 2014, lenders can only impose prepayment penalties during the first three years of your loan, and the lender must offer an alternative that does not feature a prepayment penalty.
Even if your loan has a prepayment penalty, you might not have to pay, depending on the situation. For example, a “soft” prepayment policy allows you to get out with no penalty if you sell your home or just decide to pay make bigger-than-required payments to pay down your debt faster—but you pay a penalty charge if you refinance into a different loan. A hard prepayment policy dings you no matter whether you sell, refinance, or make extra-large payments.
Auto loans may also come with prepayment penalties. As you review offers from lenders and dealers, ask if there is a prepayment penalty. Just to be sure, look for any prepayment penalty clauses in your loan agreement and disclosures.
Other Types of Loans
- Student loans should not have prepayment penalties. Those features were outlawed on private student loans in 2008 and federal student loans do not include penalties.
- Business loans from the SBA may feature prepayment penalties, so it’s critical to review your loan agreement if there’s any chance that you’ll pay off the loan early.
- Personal loans might have penalties but many popular online lenders offer loans with no prepayment penalties.
How Much Are Prepayment Penalties?
Lenders can calculate your penalty amount in several different ways. The specifics depend on things like your loan agreement and the amount you pay, so it’s wise to familiarize yourself with the details of any loan you’re considering. Be sure to compare offers from multiple lenders so you can choose the loan that works best for you.
Percentage of Loan Balance
Some lenders charge a percentage of the outstanding loan balance you pay off. For example, if you owe $100,000 and the penalty is 3%, you pay a $3,000 prepayment penalty. In those cases, smaller debts—or smaller prepayments—can result in a lower penalty amount. Lenders may set a cap on your prepayment penalty, making it the lesser of a dollar amount or the percentage you pay off.
Other loans calculate penalties based on how much interest you would have paid if you’d kept the loan for a longer period. Calculations vary by lender and may be based on several months’ worth of interest. For example, a loan might require that you pay three or six months’ worth of interest if you refinance early.
Some lenders assess a flat fee for prepayment. For example, a bank might charge $500 for prepaying a home equity line of credit (HELOCs) within three years. As noted above, you could end up paying either a flat fee or a percentage of your loan balance, so it’s critical to read the fine print.
A prepayment penalty might cost less than you think. If you can pay the lesser of a flat fee or a percentage of your loan balance, the flat fee might be relatively small, making prepayment more appealing.
How to Avoid Prepayment Penalties
You can dodge prepayment penalties in several ways. Paying down a loan on the standard schedule is the obvious way to do so. But what if you want to pay off the debt early? Whether you’re trying to save on interest or you need to pay off a home loan and move, a variety of strategies may be available.
Pay Only a Portion
If your primary reason for paying down debt is to reduce borrowing costs, ask your lender how much you can pay off without any penalty. Some loans allow you to prepay a portion of your loan balance (20%, for example) without incurring a penalty. Likewise, extra monthly payments in addition to your scheduled payment may not trigger a penalty but a large lump sum payment can result in penalty charges.
Choose Penalty-Free Loans
You can avoid prepayment penalties altogether if you select loans that have no prepayment penalties. If you’re in the market for a mortgage, an FHA loan may fit the bill. When it comes to personal loans, numerous options are available with no prepayment penalty attached.
Wait It Out
Penalties can change over time—they might decrease or disappear entirely after several years. For example, some home equity loans only charge penalties during the first two or three years. Research how your loan works to learn when any penalties drop off. Waiting for just a few months could save you a substantial amount of money.
- Some loans feature prepayment penalties that result in additional charges when you pay off debt early.
- Prepayment penalties help lenders receive revenue that they expected to receive—but risk losing—if you eliminate debt more quickly than anticipated.
- Penalties could apply to a variety of loans, including home loans, auto loans, business loans, and more.
- A prepayment penalty can be a significant amount of money, so it’s crucial to identify your risk (and any opportunities to dodge fees) when you apply for a loan.