What are Prepayment Penalties and Why Do They Matter?

Want to pay off your loan early? That’s great. Paying off loans as soon as you can is one of the best ways to ensure a better financial future. But before you make that final payment, you may want to check one small thing: Is there a prepayment penalty? 

What’s a prepayment penalty, again? 

A prepayment penalty is a fee that a borrower must pay a lender if the loan is paid back ahead of the predetermined schedule. Prepayment penalties vary widely between lenders and types of loans, ranging anywhere from 1–5% of the entire loan. Not every loan has a prepayment penalty. Personify Financial loans allow prepayment without penalty, no matter how early you pay off your loan. By educating yourself about loan prepayment penalties, you can learn how to erase your debt and save money on fees. 

Why do lenders charge prepayment penalties? 

It sounds unreasonable. Wouldn’t a lender be happy to receive the money they loaned you in full, ahead of schedule? Well… not really. When you return that borrowed money ahead of schedule, you reduce the amount of money the lender earns from the interest. Prepayment penalties give banks, credit unions, and other loan providers a way to recoup their costs while still potentially making a profit. Prepayment penalties may also discourage borrowers from paying debt early.  

Note: While it’s uncommon, some lenders may charge a prepayment penalty if you pay off a large portion of your balance at once—even if you don’t get the debt down to zero. As the Consumer Financial Protection Bureau advises, always read the fine print on rates, terms, and other fees in a contract. Ask your lender any questions you may have before agreeing to a loan, as well.  

How do prepayment penalties work? 

For mortgages, auto loans, and personal loans, lenders can assess prepayment penalties in several ways. These may include:  

  • Fixed flat fee: The prepayment penalty is a lump sum. 

  • Percentage of remaining balance: For example, you may have to pay 2–5% of the remaining balance. 

  • Sliding scale: The fee changes based on how long you’ve had the loan for or how much you have left to repay. The prepayment penalty decreases over time (e.g., the prepayment penalty will be higher if you have 10 years left on your mortgage as opposed to 3 years). 

  • Percentage of 6 months of interest: ValuePenguin data shows that many lenders charge prepayment penalties of 80% of 6 months’ worth of interest. 

If you think that the latter is unnecessarily confusing, you’re right. This type of prepayment penalty is growing in popularity in part because it’s harder to figure out how much you’ll actually owe if you pay early. 

So… should you pay off any loan early?  

More often than not, prepaying your loan is a great idea. Even though you may pay a prepayment penalty, you’ll still greatly reduce the amount of interest you have to pay overall. Not to mention that paying off a loan early and in full can give you peace of mind, which is priceless. After all, more than 50% of Americans with debt say that it’s negatively affected their lives, according to an American Institute of CPAs survey

You should prepay loans with high interest rates if you can. You’ll save lots of money on interest—even with a prepayment penalty.  

The bottom line about prepayment penalties 

Prepayment penalties vary widely. When you shop for a loan, it’s important that you do your due diligence. Ask for the prepayment disclosure before closing with any lender. Then, do the calculations on your own to figure out exactly how much you’d have to shell out if you chose to pay your loan off early. Always calculate the cost of borrowing. Go with the loan that is most affordable on a monthly basis and saves you money on interest fees and other charges. Keep in mind that sometimes loans with prepayment penalties are cheaper than loans without such penalties. It all depends on your rates and terms. 

 

The material presented here is for informational purposes only and does not represent specific financial advice to you or your circumstances personally.