Prepayment Penalties: Why They Exist and How to Avoid Them

May 13, 2018 · 6 minute read

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Prepayment Penalties: Why They Exist and How to Avoid Them

If you recently got a bonus or just sold off the antique nutcracker collection you inherited from your Uncle Leo, you might consider putting that extra cash toward paying off your loans or getting ahead on your mortgage. After all, one frequently given nugget of financial wisdom is to use unexpected windfalls to pay down your debt. But what happens when paying down your loans comes with a prepayment penalty?

Loan prepayment penalties are fees lenders might include in their terms to ensure you pay a certain amount of interest on your loan before paying it off. It might sound crazy, but making extra payments or paying your loan off early can actually cost you more because of loan prepayment penalties.

The best way to avoid prepayment fees, of course, is to choose a personal loan or mortgage without prepayment penalties. If you’re stuck with a prepayment penalty on your loan, however, all is not lost. There are ways to avoid paying loan prepayment penalties. Here’s what you need to know in order to avoid prepayment penalty fees.

Can You Pay off a Loan Early?

Let’s look at a quick hypothetical: Say you took out a $5,000 personal loan three years ago. You’ve been paying it off for three years, and you have two more years before you’re finished paying it off. But then let’s say you find yourself with some extra cash and you want to use that money to pay off your personal loan early.

Can you pay off a personal loan early? It depends on your lender. Some lenders offer personal loans without prepayment penalty fees. However, others will charge you a fee for paying your loan off early. A prepayment penalty is commonly charged on mortgage loans, but they can show up if you pay off a personal loan early, too.

What is a Prepayment Penalty Fee?

A prepayment penalty is when a lender charges you a fee for paying off your loan early. If you think it’s frustrating that a lender would charge you for paying off a loan too early, you’re not wrong. When you borrow money, you might think a lender would appreciate being repaid as quickly as possible?

In theory, yes. But in reality, it’s not that simple. Lenders make most of their profit from interest, so if you pay off your loan early, the lender is possibly losing out on the interest payments that they were anticipating. Charging a prepayment penalty is one way a lender may recoup their financial loss when you pay off your loan early.

Lenders might calculate the prepayment fee based on the loan’s principal or how much interest remains when you pay off the loan. The penalty could also be a fixed amount that was decided on when you signed up for the loan.

Differences in Prepayment Penalities

Because the terms of personal loans vary, the best way to figure out how much a prepayment fee would be is to check a loan’s terms before you decide on one. Lenders have to be upfront about how much the prepayment penalty will be; They’re required by law to disclose that information before you take on the loan.

Personal Loan Prepayment Penalties

For example, if you take out a $6,000 personal loan to turn your guest room into a pet portrait studio and agree to pay your lender back $150 per month for five years, the term of that loan is five years. Although your loan term says it can’t take you more than five years to pay it off, some lenders also require that you don’t pay it off in less than five years.

The lender makes money off the monthly interest you pay on your loan, and if you pay off your loan early, the lender doesn’t make as much money. Loan prepayment penalties allow the lender to recoup the money they lose when you pay your loan off early.

Mortgage Loan Prepayment Penalties

When it comes to mortgages, things get a little trickier. For loans that originated after 2014, there are restrictions on when a lender can use prepayment penalties, which has made the penalties less common on mortgages.

If you took out a mortgage before 2014, however, your mortgage may be subject to loan prepayment penalties. If you’re not sure if your mortgage has a prepayment penalty, check your origination paperwork or call your lender.

What is a Prepayment Clause?

As we’ve said, a prepayment penalty fee is not something that is hidden from you until you decide to pay off your loan early. Lenders lay out whether or not they charge you a prepayment penalty when you sign on for your personal loan. It’s all explained in the prepayment clause of your loan agreement.

It might be in the fine print, but the prepayment clause is there. (And yes, that’s reason 1,001 why it’s always good to read the fine print. Don’t you hate it when your parents’ advice turns out to be right?) If you’re considering paying off your personal loan early, check your loan terms to determine whether or not you have to pay a prepayment penalty.

How Much Are Loan Prepayment Penalties

The cost of the prepayment penalty can vary widely depending on whether you took out a small personal loan or a substantial mortgage, and how your lender calculates the penalty. Lenders have different ways to determine how much of a prepayment penalty to charge.

It behooves you to figure out exactly what your prepayment fee will be, because it can help you determine whether the penalty will outweigh the benefits of paying your loan off early. Here’s how the penalty fee might be calculated:

1. Interest Costs. If your loan charges a prepayment penalty based on interest, the lender is basing the fee on the interest you would have paid over the total term. To take our example from above, if you have a $6,000 loan with a five-year term, and want to pay the loan off in full after only four years, the lender may try to charge you 12 months’ worth of interest as a penalty.

2. Percentage of balance. Some lenders use a percentage of the amount left on your loan to determine your penalty fee. This is a common way to calculate prepayment penalty fees on mortgages. For example, if you buy a house for $500,000 and want to pay off the remaining balance six months after purchase, your lender might require that you pay a percentage of your remaining balance as a penalty.

3. Flat fee. Some lenders also simply have a flat fee as a prepayment penalty. This means that no matter how early you pay your loan back, you’ll have to pay a previously-agreed-to penalty fee.

How to Avoid a Prepayment Penalty

Trying to avoid prepayment penalties can seem like an exercise in futility, but it is possible. The easiest way to avoid them is to take out a loan or mortgage without prepayment penalties. If that is not possible, you still have options.

If you already have a personal loan that has a prepayment penalty, and you want to pay your loan off early, talk to your lender. You may be able to pay off your loan closer to the final due date, and sidestep the penalty. Or you might find that even if you pay off the loan early and incur a penalty, you’ll still save money on interest fees in the long run.

You can also take a look at your loan origination paperwork to see if it allows for a partial payoff without penalty. If it does, you might be able to prepay on a portion of your loan each year, which allows you to get out of debt sooner without requiring you to pay a penalty fee.

For example, some mortgages allow larger payments of up to 20% of the purchase price once a year—without charging a prepayment penalty. This means that while you might not be able to pay off the full mortgage, you could pay up to 20% of the purchase price each year without triggering a penalty.

Some lenders shift their prepayment penalty terms over the life of your loan. This means that as you get closer to the end of your original loan term, you might face less harsh penalty fees, or no fees at all. If that’s the case, it might make sense to sit on Uncle Leo’s nutcracker fortune for a year or two until the prepayment penalties no longer apply.

If you’re in the market for a personal loan, avoiding a prepayment penalty isn’t as difficult. Thankfully, there are a few lenders that won’t charge you a penalty for paying off your personal loan early. But when it comes to your money, you don’t want to make any assumptions. You still need to do your due diligence by asking the right question before you finalize the loan.

Step 1: Ask your potential personal loan lender if they have a prepayment penalty. Because of the Truth in Lending Act , lenders are required to give you a document that outlines any loan fees they’re going to charge you—and that includes a prepayment penalty.

Step 2: If the lender enforces a prepayment penalty, simply choose another personal loan lender that doesn’t. SoFi is one of the lenders that doesn’t charge a prepayment penalty.

And if you take out a loan with SoFi, you don’t have to pay any origination fees either. SoFi also offers other benefits to their borrowers; For example, there is an Unemployment Protection Program where you may be eligible to pause your loan repayment schedule if you unexpectedly lose your job.

With a SoFi personal loan, you won’t be penalized for paying your loan off early.


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