If you’re working diligently to pay off your debt early, you may be unpleasantly surprised to find out about prepayment penalties. Some lenders charge these fees when borrowers pay off their debts before their loan term expires. These penalties are designed to discourage borrowers from paying off their loans early. Some kinds of loans have prepayment penalties while others do not. Here’s what you need to know about prepayment penalties and how they can affect you.
Written by Mark P. Cussen, CFP® , CMFC.
Updated September 22, 2021
Paying off debt early can be a major financial goal. If you’re working diligently to pay off your debt early, you may be unpleasantly surprised to find out about prepayment penalties. Some lenders charge these fees when borrowers pay off their debts before their loan term expires. These penalties are designed to discourage borrowers from paying off their loans early. When borrowers do that, the lender doesn’t earn all of the interest they anticipated earning when they offered the loan.
Some kinds of loans have prepayment penalties while others do not. Here’s what you need to know about prepayment penalties and how they can affect you.
What Is a Loan Prepayment Penalty?
In a nutshell, a prepayment penalty is a fee that the lender charges borrowers who pay off their loans before the full loan term has ended. For example, if you take out a personal loan with a five-year payment schedule and decide to pay it off sooner than five years, the lender may charge you a fee equal to 1% of the loan balance.
Prepayment penalties vary by lender and loan type. They may also vary depending on when in the term you pay off the loan. Some lenders may only charge a prepayment penalty in the first few years of the loan. While they can be an inconvenience, a prepayment penalty will not affect your credit score. Just be sure to make all of your payments on time, even if you make extra payments or pay more than the minimum amount each pay period.
Prepayment penalties are commonly found in home mortgages, car loans, and personal loans. Federal Housing Authority (FHA) loans do not charge prepayment penalties, but conventional mortgages often do. When it comes to car loans, 36 states plus the District of Columbia permit lenders to charge prepayment penalties on loans with terms shorter than 60 months. But it is illegal for car loan lenders to charge prepayment penalties for loans that are 61 months or longer. For personal loans, prepayment penalties vary by lender. Some charge them while others do not.
Interest can be computed in two ways: simple interest and precomputed interest. Simple interest is computed on the balance of the loan each payment period. If you pay the loan off early, you simply save on paying future interest. Precomputed interest is calculated at the time the loan is made on the total loan amount. The lender uses this to get a sense of how much they’ll earn in interest over the life of the loan. While you may still be able to pay off this loan early, you may not save on future interest charges in the same way you do on a simple interest loan. Since lenders of precomputed loans will miss out on collecting all the interest they anticipated getting, they may charge a prepayment penalty to cover some or all of this loss.
It’s important to consider prepayment penalties when you take out a loan because they can add to the cost of the loan. Say you take out a mortgage for a home or another type of real estate and you plan to sell the home or refinance the loan within the next few years. In that case, you’ll want to get a loan that does not charge a mortgage prepayment penalty. You may have to pay a slightly higher interest rate and have higher mortgage payments to get this.
The same is true for car and personal loans. But many lenders offer loans that do not have these penalties, so be sure to shop around and let your lender know upfront that you may be paying off the loan early.
How To Find Out if Your Loan Has a Prepayment Penalty
If you have already taken out a mortgage, car loan, or personal loan and you’re not sure whether your loan has a prepayment penalty, it’s easy to find out. Simply look at the loan agreement or loan documents you signed to see if they mention prepayment penalties. You may have to read the fine print to find out. If the fine print doesn’t mention them anywhere, you probably don’t have them. You can also contact your lender directly to ask.
If you’re a homeowner, you can ask the title company where you closed your loan whether your mortgage includes a prepayment penalty or not. For other types of loans, contact your lender. They may ask for your loan number or other identifying information to look up your loan and tell you if it includes a prepayment penalty. If you got your loan from a local bank or credit union, just stop by one of their branches, and the personal banker there should be able to tell you whether your loan has a prepayment penalty or not.
Other Questions for Your Lender
While you’re finding out about your prepayment penalty costs, stop to think about whether you have any other questions about your loan. You may need to know whether your loan has a fixed or variable interest rate, the amount of your remaining balance, or whether your loan term can be extended. You can also ask about changing the amount of your monthly payment and whether you were charged an origination fee. Your lender can answer any and all questions you have about your loan. They can also help you to get new financing if you are dissatisfied with the answers you get about your current loan.
Lenders Must Disclose Fees
If you are shopping for a new loan, ask the lender whether the loan has any prepayment fees. Most lenders will disclose this fee when they give you a loan estimate. Many lenders offer loans without this penalty, and a quick internet search will provide a list of lenders in this category. Lenders are required by law to tell you if they charge a prepayment penalty fee, just as they are required to disclose all other loan terms, such as the interest rate and length. If a lender charges you a prepayment penalty and there is nothing in the loan documents that notifies you of this fee, you can report them to the Consumer Financial Protection Bureau (CFPB). The CFPB may be able to intervene on your behalf and get the fee waived if you can prove that the lender never told you about it.
The Special Case of Student Loans
If you have federally subsidized student loans, you won’t have to worry about prepayment penalties. Federal law prohibits lenders from charging this fee under any circumstances. So if you need to consolidate or refinance your student loans, you’ll never pay a penalty of any kind.
But there are other factors to consider when it comes to paying off student loans early. Student loans are usually the last type of loan you should pay off because of their relatively low interest rates and tax benefits. Most financial advisors will tell you to first put any extra money you have into an emergency fund, then maximize your retirement savings. Once you have accomplished these two objectives, you can focus on paying off your high-interest debts such as credit card debt or personal loans.
Prepayment Penalties and Refinancing
Prepayment penalties aren’t just charged for simply paying off a loan early. They can also be charged if you decide to refinance a loan. This is common with mortgages. When you refinance your home, you get a new loan to pay off the old mortgage loan. In this case, if your loan contract includes a prepayment penalty, you’ll have to pay it when you refinance your debt.
In some cases, it may still be worth refinancing and paying the fee. It will depend on how much the fee is and how much money you could save by refinancing. You’ll need to do some math to determine this. Your mortgage broker or banker can help you use a financial calculator to figure this out. Financial calculators take all the loan variables into account, including the interest rate, number of compounding periods, term of the loan, and initial loan balance. They can also factor in the prepayment penalty fee to find out exactly whether you will still come out ahead by refinancing your debt. It’s important to be clear about which choice is best before you make a decision.
Prepayment penalties are commonly found in residential mortgage loans, auto loans, and personal loans. Some mortgage lenders charge this fee while others do not. Some lenders charge prepayment penalties only on certain types of loans.
If you already have a loan and you aren’t sure if it has a prepayment penalty, it’s important to find out. Check your loan documents or contact your lender directly to ask about it. If you’re considering taking out a loan, ask your lender whether they charge this fee and, if so, how much it will be. By law, they must tell you. You are probably wise to shop for a loan that does not have this fee if you plan on selling your asset or refinancing your debt within a relatively short period of time.