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What is a Prepayment Penalty for Debt?

Lenders make their money off of the interest paid to them and when a loan is paid off too quickly, they make less than anticipated. In this scenario, a prepayment penalty may kick in.

July 13, 2021

The word “penalty” in the question above probably gives you a clue that it may not be something super desirable. 

You’re right that you don’t want a prepayment penalty clause included in the terms of a debt you owe. Sort of the opposite of a late fee, these clauses often state that if the borrower pays off or significantly pays down a loan within the first three years of its term, they’ll incur a financial penalty. Most commonly, prepayment penalty clauses are found in mortgages. 

The penalty may be a percentage that’s calculated on the balance remaining on your mortgage. Alternatively, it may be the equivalent of a certain number of months’ worth of interest, or it may be determined another way. What’s important is to check any mortgage note you’re

Why Do Lenders Use Penalties for Paying a Loan off Early?

Lenders make their money off of the interest paid to them and, when a loan is paid off too quickly, they make less than anticipated. Lenders may offer a lower introductory interest rate, making principal and interest payments more affordable to entice borrowers to choose them. 

In this case, these lenders expect to make more money from the borrower in the upcoming years. So, if a borrower pays off a loan within a couple of years, the lender won’t make the money it anticipated. This includes, but isn’t limited to, if the borrower pays off the loan through refinancing. In other words, these penalties are a way for lenders to manage risk and ensure that the mortgage programs they offer are profitable.

Spotting Loan Prepayment Charges

A lender must disclose the prepayment clause during closing. This penalty cannot be enforced without the borrower’s knowledge of its inclusion and terms. That said, when shopping around for a mortgage, it makes sense to find out information about potential repayment penalties early on. 

Effective January 10, 2014, limits were put into place about when a lender can charge this kind of penalty. When prepayment penalties are allowed, they can only be in effect during the first three years of the mortgage. The penalty amount also comes with a mandatory cap; it can’t be greater than 2% of the outstanding loan balance and, during year three, the cap is set at 1% of the outstanding balance.

A lender can, in general, include a loan prepayment penalty clause if these criteria are met:

  • The APR can’t increase after the loan is taken out (such as with a fixed loan rate).
  • The loan is “qualified” with stable terms. It has no features that can make it a risky loan, such as the inclusion of interest-only payments or negative amortization. 
  • The APR is not higher than a metric called the Average Prime Offer Rate.

If a lender offers a loan with an early repayment penalty, it must also have a reasonably comparable loan program that doesn’t include it. This no-penalty alternative must be designed in a way that, in good faith, the lender believes the consumer qualifies for.

If a borrower chooses a loan program with a penalty, information about that penalty must appear on periodic billing statements or in the payment coupon book, as well as in any interest rate adjustment notices.

Some lenders allow borrowers with a penalty clause in their mortgage to prepay part of their loan early, but not in its entirety. For example, a loan note may indicate that you can pay up to 25% of your outstanding loan balance each year without penalty. Or the penalty amount may go down incrementally. 

If you’ve already signed a contract that contains this penalty and it’s in effect, you can calculate the current amount you’d owe. Let’s say that you’ve got a remaining mortgage balance of $150,000 with a 5% interest rate, and the early repayment penalty equals six months’ worth of interest. The penalty would then be approximately $3,750 ($150,000 * 0.05 = $7,500; $7,500/12 * 6 = $3,750).

Using the same scenario, if a loan prepayment penalty is considered to be 2% of the outstanding balance, it would be $3,000 ($150,000 * 0.02).

Loan Prepayment Penalty: Personal Loans and Car Loans

Although an early repayment penalty is most often discussed in connection with mortgage loans, some lenders may charge them on personal and car loans, so make sure you understand what you agree to when signing any note. You could also negotiate a program without an early repayment penalty, although a lender doesn’t have to agree. 

You’ll never find a prepayment penalty on student loans. These penalties are not part of federal student loan programs, and their inclusion has been banned in private student loans since 2008.

Plus, federal credit unions can’t charge loan prepayment penalties. However, if your credit union is state-chartered, note that some states allow these penalties under certain circumstances. 

Should You Ever Pay an Early Repayment Penalty?

This penalty is designed to help and protect the lender. It doesn’t provide benefits for the consumer. That said, there may be situations where paying the penalty can make sense. 

For example, if you get an unbelievable offer to buy your home in a hot neighborhood or find an incredible refinance rate, it might be time to do the math. In select circumstances, paying off the mortgage can be financially advantageous for you, even if loan prepayment charges are included in the payoff. 

Tally and Your Finances

Prepayment penalties come into play when you pay down a mortgage or loan fast. When you’re considering a mortgage or other loan, make it a point to read through the fine print to see if the lender included a prepayment clause. 

However, there are other forms of debt where you can save money by paying them down quickly. If you’re looking for a way to pay down your consumer debt faster, consider Tally. This debt repayment tool can help consolidate credit card debt and pay it down faster and smarter.