What Is a Prepayment Penalty?

Prepayment penalties — sometimes called exit fees or prepay fees — are extra charges a lender may apply if you pay off your loan early. Here are some key points to know:

• Different types of loans have different rules for early repayment.

• Mortgage lenders, for example, may allow you to pay off a portion of your loan — like 20% per year — before a penalty kicks in.

• Lenders charge prepayment penalties because they expect to earn interest over the full loan term. If you pay early, they lose potential earnings.

• Not all lenders have prepayment penalties. Before finalizing a loan, check if one applies.

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Why Do Lenders Impose Prepayment Penalties?

When you pay off your loan ahead of schedule, that impacts the lender's expected interest income. If the lender was counting on that interest income, a prepayment penalty can help to offset the lost interest charges.

Ultimately, imposing a prepayment penalty offers a way for lenders to mitigate financial risks.

How Are Prepayment Penalties Calculated?

Different lenders impose prepayment penalties in different ways. Below is a look at some of the common ways you may encounter a penalty.

Percentage of Remaining Loan Balance

In some cases, a lender will charge a prepayment penalty equal to a percentage of the remaining loan balance.

For example, a 2% penalty on a $100,000 remaining balance equals a $2,000 fee.

Fixed Number of Months Interest

In some cases, a lender will charge a fee equal to a fixed number of months' worth of interest.

For example, six months' interest on a $100,000 personal loan at a 5% interest rate results in a $2,500 penalty.

Sliding Scale Based on Loan Age

With a sliding scale prepayment penalty, the fee depends on how much is left on the loan when you pay it off early. The penalty is calculated as a percentage of the remaining balance. Here's an example:

Types of Prepayment Penalties

You might hear two different terms when it comes to prepayment penalties: hard prepayment penalties and soft prepayment penalties. Below is a closer look at each.

Hard Prepayment Penalty

A hard prepayment penalty is charged when the borrower pays off the entire loan balance early or, in some cases, refinances. In some cases, this may even apply if you pay off a portion of your loan early.

Soft Prepayment Penalty

Soft prepayment penalties occur only when you refinance or take out a new loan, usually leading to longer terms and lower interest rates. For example, this penalty might not apply if you sell the home.

Examples of Prepayment Penalties

Prepayment penalties are especially common with mortgage and auto lenders. Here are some examples of prepayment penalty styles.

Mortgage Loans

Imagine you want to pay off your mortgage balance of $200,000 early thanks to a windfall. The lender chooses to impose a 2% prepayment penalty on the remaining loan balance. With that, you'd face a fee of $4,000 if you pay off the entire balance at once.

Auto Loans

What if you have an opportunity to pay back your auto loan early? The remaining loan balance is $20,000 and the lender charges a 1% prepayment penalty, which means you'd pay a fee of $200 to pay off the loan early.

Depending on the loan, paying back your balance ahead of schedule may be worth it even if you have to deal with a prepayment penalty.

Although you'll pay a fee, you'll avoid future interest charges on the loan and eliminate a monthly payment from your budget.

How To Avoid Prepayment Penalties

Prepayment fees work in favor of lending institutions with no benefit to borrowers. You might not even think to ask about exit fees when you sign your loan documents, which could later prove to be a costly mistake if you're planning an early loan payoff.

Here are some tips on avoiding them:

Loan Shopping

Different lenders have different policies on prepayment penalties. As you consider your loan options, shopping around can help you find a lender without prepayment penalties.

Negotiation

If you notice a prepayment penalty before signing the loan documents, take the opportunity to ask for that section of the contract to be removed. Although it's rare, a lender might be willing to pull back on this area of the contract.

After you sign the loan paperwork, negotiating for a lower prepayment penalty is difficult. But it never hurts to ask, you might be surprised to find that some lenders are willing to work with their borrowers.

Understanding Loan Terms

Take the time to evaluate the total cost of the loan you're taking out — including all the loan fees. Here are some to watch for:

• Origination fee: This is a fee charged by the lender for processing the loan, usually a percentage of the loan amount. Be sure to compare rates, as some lenders charge higher fees than others.

• Additional fees: Some loans come with extra costs, such as

  inspection, appraisal or broker charges.

• Exit fees: If your loan includes prepayment penalties or other fees for paying it off early, factor these into the overall cost.

Before signing a loan agreement, look for "no prepayment penalty." If it's not mentioned, ask your lender directly. Understanding this upfront can help you avoid unexpected fees if you decide to pay off your loan early.

If you're negotiating loan terms, ask if a simple-interest loan with no prepayment penalty is available. Shopping around and comparing offers from banks and credit unions can help you secure the best loan for you.

FAQs

Can I make extra payments without incurring a prepayment penalty?

In some cases, you can make extra payments without incurring a prepayment penalty. But whether or not you can varies based on the lender you work with.

Are prepayment penalties legal?

Yes, prepayment penalties are legal in many states. If you sign a loan document that includes details of a prepayment penalty, that's legally binding.

How can I find out if my loan has a prepayment penalty?

You can determine if your loan has a prepayment penalty by reviewing the loan documents. If you aren't sure about the fine print, call your lender to determine whether or not a prepayment penalty exists.

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