What Is a Prepayment Penalty and How To Deal With One

FT Contributor
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Whether you’ve suddenly encountered a windfall or have been saving money for some time, you may be eager to pay off your loans in their entirety. While having the financial security to pay off your loans isn’t necessarily a bad thing, you should be careful when it comes to paying back loans early. Paying off your loans before they’re due might result in a prepayment penalty, and could cost you more in the long run.

What Is a Prepayment Penalty?

A prepayment penalty is a fee you’ll have to pay if you attempt to pay off your loan prior to the agreed-upon date. Not all loans have prepayment penalties, and prepayment penalties are becoming less common in general. Despite this, it’s important to go over the terms of your loan to ensure you won’t incur a penalty for paying off a loan ahead of schedule.

Prepayment penalties are most common when it comes to paying off mortgages. Lenders charge prepayment penalties in order to protect their own investment, and to ensure that they make a profit on the loan, either through a fee or through accumulated interest. Prepayment penalties can help to ensure that you pay off your loan on the agreed-upon timetable, and can make it more difficult to quickly sell or refinance a property. Typically, a prepayment penalty applies within the first three to five years of the loan.

The amount of a prepayment fee will vary depending on your specific financial situation, including the size of the loan and the amount that you pay off early. The terms of most loans vary from lender to lender, so it’s important to read the fine print and know exactly what you’re getting into. Many lenders calculate a prepayment fee based on a percentage of the interest you would have owed on your loan had you continued to pay it off according to schedule.

Why Do Lenders Charge Prepayment Fees?

Lenders charge prepayment fees in order to ensure that they turn a profit on a loan. If you pay back your loan early, lenders don’t earn as much interest. In order to avoid this, lenders use prepayment penalties to discourage you from paying off your balance early and to recoup a certain amount of lost profit if you decide to pay off the loan ahead of schedule. Essentially, the prepayment penalty makes up for the lost interest that the lender would have profited from had the loan been paid off according to plan.

Are Prepayment Penalties Always Legal?

Prepayment penalties aren’t always legal. While some states have banned prepayment penalties, other states have not. In addition, some banks are regulated by the federal government rather than the state. Federal law prohibits some mortgages from coming with prepayment penalties.

In general, regulations surrounding prepayment penalties are designed to protect consumers against predatory loan terms and encourage borrowers to pay off loans when appropriate. After the 2008 financial crisis, the government enacted stricter regulations concerning mortgages and prepayment penalties, including the 2010 Dodd-Frank Act. This legislation prohibits prepayment penalties on most mortgage loans, with a few exceptions. However, these new rules don’t apply to pre-2014 mortgages.

What Loans Have Prepayment Penalty Fees?

Not many loans have prepayment penalties, and in general prepayment penalties have become less common over time. The main category of loans that may be subject to a prepayment penalty is mortgages.

Mortgages

Prepayment penalties for mortgages have become less common since the 2008 financial crisis. You’re more likely to incur a prepayment penalty if you pay off a large chunk of the loan before the designated repayment period, or if you refinance your house.

Terms vary from lender to lender, so it’s important to read the fine print and know exactly what fees may result if you decide to pay off a loan early. Prepayment penalties are often calculated based on the outstanding loan balance. In general, lenders are prohibited from charging a prepayment penalty that is greater than 2% of the remaining loan balance.

Other Loans

Other loans that could potentially come with prepayment penalties include personal loans, auto loans, or a home equity line of credit (HELOC). While it is possible to incur a prepayment penalty when you pay off these types of loans early, it’s fairly uncommon. Student loans are not subject to a prepayment penalty if you pay them off ahead of schedule.

How to Deal With Prepayment Penalties

If you’re thinking about taking out a loan, or paying one off ahead of schedule, it’s important to read the fine print and to be aware of any fees or penalties surrounding the loan.

Under the regulations set forth in the Dodd-Frank Act, lenders are obligated to include information about prepayment penalties if they are relevant. This information can usually be found on your periodic billing statement, as well as on any interest rate adjustment notices. Prepayment penalties may also be included in your loan estimate and closing documents, or in the “Addendum to the Note” of a mortgage.

If you’re trying to avoid prepayment penalties, keep in mind that these fees are usually negotiable. If you’re considering paying off a loan that has a prepayment penalty ahead of schedule, it’s a good idea to calculate how much the fee will cost and how much money you stand to save. In many cases, paying off loans early is a good idea despite the additional fee. In other situations, however, continuing to pay off loans on the agreed-upon schedule can free up any lump sums to pay down other debt, invest, or make new purchases.


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