Published in: Personal Loans | May 12, 2020

What's the Idea Behind a Prepayment Penalty?

By:  Dana George

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Knowing more about prepayment penalties makes it easier to avoid them.

A young couple meeting with a bank representative asking them to sign papers.

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Asking questions is what makes you a smart consumer. One question that sometimes falls between the cracks, though, is whether a lender charges a prepayment penalty. If you're not quite sure what a prepayment penalty is, you've come to the right place. Here, we'll tell why prepayment penalties exist, how they work, and how to avoid them.

What is a prepayment penalty?

A prepayment penalty is a fee some lenders charge for paying a loan off earlier than originally scheduled. Lenders make money by charging their customers fees for everything, from loan origination fees to closing costs. But the primary reason they're in the loan business is to collect interest payments. 

Say you borrow $200,000 to buy a home. You take out a 30-year mortgage with a 5% APR, and your monthly principal and interest payments are $1,074. After 30 years, the lender will have earned $186,640 in interest alone. But, if you decide to pay the loan off early or refinance, the original lender misses out on all those interest payments. To ease the pain, they might charge you a prepayment penalty. 

Types of prepayment penalties

There are two types of prepayment penalties: soft and hard. If a lender charges a fee only when you refinance a loan, but not when you pay it off, the penalty is considered soft. If you're hit with a fee for prepaying your loan under any circumstances, it is a hard penalty. 

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Prepayment penalties by loan type

Not all lenders are created equal, and not all charge a prepayment penalty. It often depends on the laws of their home state and whether prepayment penalties fit with their business model. It also depends on the type of loan. Prepayment penalties are most often associated with mortgages, although it pays to check any loan you're considering for a prepayment penalty clause. 

Mortgage

As the U.S. was coming out of the Great Recession, Congress decided to get serious about cleaning up the mortgage banking industry and set up the Consumer Financial Protection Bureau (CFPB). At the start of January 2014, the CFPB put limits on prepayment penalties. The new rules mean that prepayment penalties cannot be charged after the first three years of a mortgage. If a loan is prepaid during the first two years, the lender can only charge a prepayment penalty of 2% of the outstanding balance. If it is prepaid during the third year, it can charge 1% of the mortgage balance. 

A prepayment penalty can only be included on certain types of loans. While it's legal to charge the fee on conventional mortgages, lenders cannot include a prepayment penalty on FHA, VA, or USDA mortgages. The new regulations also say that lenders must offer a prepayment-free option that they believe the customer is likely to qualify for. 

The 2014 laws do not apply retroactively, so if you took out a mortgage before then, the three-year rule does not apply. That does not mean that every pre-2014 mortgage includes a prepayment penalty, though. As is the case today, some lenders tacked them on and some did not.

Personal loans

A personal loan from a lender located in a state that allows prepayment penalties may leave you saddled with an inability to pay it off early. That's because laws governing loans are based on the state in which the lender is located. 

Auto loans 

Although uncommon, some lenders slip a prepayment penalty into their auto loan contracts. 

How prepayment penalties are calculated

The way lenders calculate prepayment penalties varies by lender, loan type, and the date the loan was made. For example, if you have a mortgage that was taken out before the rules changed in 2014, you may be charged a prepayment penalty equal to 80% of six months' interest. Say your monthly mortgage payment included $600 in interest.That means over the course of six months you would pay $3,600 in interest. The lender would multiply that $3,600 by 0.80 to arrive at a prepayment penalty of $2,880. 

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How to avoid prepayment penalties

Add "prepayment penalty" to the list of features you should check when rate shopping. Now, in addition to the annual percentage rate (APR) and repayment terms, you also need to know each lender's policy on prepayment. According to the CFPB, a lender must tell you whether there is a penalty for paying a loan off early. 

You have the right to negotiate to have the penalty removed from the contract or to ask a lender for a different type of loan. Do not sign anything until you know for sure there is no penalty for early payment.

If it's too late and you're already committed to a loan with a prepayment penalty and you want to get out of your loan early, it's time to re-negotiate. Ask the lender to waive the fee. If you're working with a bank or credit union you have already established a relationship with, they may be agreeable in order to keep your business. 

If the loan in question is a mortgage and you want to sell your home, crunch the numbers to decide if the proceeds you expect to receive are enough to offset the penalty fully. If the loan in question is a personal or auto loan, decide if the money you're going to save by paying the loan off early is enough to make up for the amount lost to a prepayment penalty.  

Although prepayment penalties are not as common as they once were, being on the lookout for them can still save you money.

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