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Paying off debt ahead of schedule feels like a financial win, but with some personal loans, it could actually cost you money. Certain lenders charge a loan prepayment penalty when you pay off your loan early, which can offset or even exceed the interest savings you were counting on.
Before you put that extra cash toward your loan balance, it’s worth taking a closer look at the fine print to make sure early repayment is actually the right move for you.
Key Points
• A prepayment penalty is a fee lenders charge to recoup lost revenue when you pay a loan off early.
• Penalties are typically a fixed fee, a percentage of your balance, or several months of interest.
• Prepayment penalties are common for mortgages but rare for personal loans.
• Review your loan contract or ask your lender to ensure savings outweigh the penalty before paying early.
• Early payoff can temporarily lower your credit score by impacting credit mix and utilization.
What Is a Prepayment Penalty?
When you take out a personal loan, your lender charges interest. This is how it earns revenue on the money you borrow. However, if you pay off the loan early — partially or in full — that revenue stream dries up. To compensate, a lender may charge a prepayment penalty for the money it’s missing out on.
How Do Prepayment Penalties Work on Personal Loans?
Personal loans are a type of installment loan. They can be used for a variety of purposes. You might use one as a credit card consolidation loan, for example. Or you could use one as a home improvement loan.
You’ll pay it back the loan in regular monthly payments that include interest. Penalties for paying off a personal loan early will typically vary by lender.
How Prepayment Penalties Are Calculated
In general, prepayment penalties are calculated in one of three ways: as a percentage of the loan balance, as a fixed fee, or as an equivalent of a certain number of months worth of lost interest. Depending on the method your lender uses, the penalty could range from a few hundred to a few thousand dollars, so it’s important to know what you’re dealing with before making any extra payments.
Are Prepayment Penalties Common on Personal Loans?
Prepayment penalties are relatively uncommon for personal loans, though some lenders do charge them. They are much more common for mortgages, where lenders stand to lose years of interest revenue if a borrower pays off early. Personal loans, by contrast, tend to involve smaller amounts and shorter terms of just a few years, so the stakes for lenders are lower. This is why you’ll often see offers for a no prepayment penalty personal loan.
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Benefits and Drawbacks of Paying Off a Personal Loan Early
The primary benefit of paying off a personal loan early is the potential to save money on interest. Imagine you took out a $20,000 loan with a 10% interest rate that you’re paying back over five years. Your monthly payment would be approximately $425, and over 60 months you’d make $25,500 in payments including interest.
If you paid an extra $100 a month, you’d pay off your loan 15 months early and you’d make a total of $23,625 in payments, including interest. That’s a savings of $1,875.
That said, if there is a loan prepayment penalty, paying off your loan could cost you more than it saves you. In the example above, if you had a prepayment penalty of $2,000, you would be in the hole $125 if you prepaid the loan. The bottom line: It is very important to know what your prepayment penalty is, and to do the math, before you make any prepayments.
Another surprising drawback of prepaying your personal loan: paying off a loan early can hurt your credit score. That’s because it will likely impact factors such as your credit mix and your credit utilization.
How to Find Out If Your Loan Has a Prepayment Penalty
To find out whether an existing personal loan has a prepayment penalty, start by checking your promissory note. This is the contract you signed when you closed on your loan. Search digital documents for phrases like “prepayment” or “early repayment.”
You can always call your lender and ask directly whether your loan has a prepayment penalty or ask for a loan pay-off statement, which will detail how much it will cost to pay off your loan, how much money you could save on interest, and any prepayment penalty.
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How to Avoid Prepayment Penalties
The best way to avoid loan prepayment penalties is to steer clear of loans that include them. Lenders are required to disclose all fees before you accept a loan. So when you’re shopping for one, be careful to check the fine print, checking loan documents for a prepayment clause.
If you already have a loan, and it has a prepayment penalty, you may still have options. Check your loan documents. While you may be penalized for paying the loan off in full, you may be allowed a partial payoff that would allow you to pay a little bit each month without penalty.
Prepayment penalty terms may also shift over the life of your loan. For instance, while there may be a penalty early in the loan term, you might get the chance to pay off your loan in full closer to the end of your loan term without penalty. As a result, if you are considering prepaying your loan, you might want to wait a couple years for the penalty to decrease.
The Takeaway
Prepayment penalties are relatively uncommon for personal loans, but they do exist, and ignoring them could cost you. Before making any extra payments, be sure to check your loan’s promissory note or contact your lender to understand what fees may be involved.
If your loan does have a penalty, run the numbers and make sure the fees don’t outweigh the advantages of early payments. When shopping for a personal loan, look for loans without prepayment penalties, so you have the flexibility to pay it off on your own terms.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.
FAQ
What is the difference between a hard and soft prepayment penalty?
A hard prepayment penalty is a fee charged when you repay a loan early by any means at any time. A soft prepayment penalty, on the other hand, is applied only when you refinance your loan or pay off a significant portion of the balance during the first years of your term.
Can you negotiate away a prepayment penalty?
It is absolutely worth contacting your lender to negotiate this fee, and your lender may reduce it. Because of the nature of the fee, however — lenders are using it to recoup lost revenue — it may be unlikely that your lender will waive the fee entirely.
Do all lenders charge prepayment penalties on personal loans?
Not all lenders will charge a loan prepayment penalty. In fact, they are relatively rare for personal loans. So if you are looking to borrow, shop around for a no prepayment penalty personal loan.
Will paying off a personal loan early hurt my credit score?
Paying off a personal loan early could hurt your credit score. That’s because your credit score is based on factors, including credit mix and credit utilization. Paying your loan off early can have an impact on these. However, whatever drop you experience in your score should be relatively small and temporary.
Is it still worth paying off a personal loan early if there’s a prepayment penalty?
Yes, it’s worth paying off your personal loan early if the amount you save in interest payments is more than the amount of your penalty.
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