What Is a Loan Prepayment Penalty?
When Lenders Want You to Drag Matters Out
What is a loan prepayment penalty? The concept may sound strange to anyone who's struggling to get out of debt. Simply put, a prepayment penalty is a fee that must be paid if you pay off a loan before the loan’s term. That's right, as unbelievable as it sounds, you can be punished for paying off a loan sooner rather than later. Learn more about these fees and why they're assessed, with this review.
Why Lenders Charge Prepayment Fees
Some loans are designed to last a certain number of years (such as 30-year mortgages or five-year auto loans). If you pay the loan off early, you may have to pay a penalty if a penalty was part of your loan agreement. That means you should read the fine print on any loan agreement you sign.
Prepayment penalties are generally based directly or indirectly on your remaining loan balance. The longer you’ve had your loan and the less you owe, the smaller your penalty will be. So, if you're paying a loan off a few months early, rather than a few years, you will not have to pay a huge fee, generally speaking.
Loans don’t always come with prepayment penalties. In fact, they’re getting less and less common (they’re illegal in some states for certain types of loans). However, they still exist, and they are even a good idea for certain borrowers.
Prepayment penalties, along with every other provision in your loan agreement, come with tradeoffs. You’re penalized for paying your loan off early, but what do you get in return? In most cases, accepting a penalty provision allows you to get a lower interest rate on your loan. In other cases, you will not be approved for a loan unless it comes with a prepayment penalty attached.
Keep in mind that only certain types of prepayments trigger the penalty. Depending on the terms of your contract, you might be allowed to prepay a portion of your loan every year—just not the whole thing.
In addition, you might be allowed to prepay as the result of selling, but prepayment as a result of refinancing would trigger the penalty. Basically, your lender is trying to keep your business; they don’t want you to jump ship if you find better financing elsewhere.
If you’re shopping for loans and you don’t want a prepayment penalty, keep looking. Different lenders will approach your needs differently. You may have to pay a higher interest rate, which means your monthly payments will be higher, but you’ll be able to get out of the loan at any time. Again, think in terms of tradeoffs: Sometimes it costs money to have flexibility, and sometimes it’s worth it.
If you’re trying to get out of a loan with a prepayment penalty, run some numbers. Figure out how much the penalty will cost compared to your savings with a new loan. Be sure to consider the total interest cost—not just your monthly payment. Use our loan amortization calculator to see how each loan stacks up.