Prepayment Penalties: The Basics
Definition & Money Saving Tips
A prepayment penalty is a fee that lenders charge to borrowers who pay off loans “early.” Loans like auto loans and home loans are typically scheduled to last for a certain number of years (known as the term), with the loan balance reaching zero at the end of the term.
For example, five-year auto loans and 30-year mortgages are popular options. But if you repay the loan too quickly, you might have to pay extra charges, called a prepayment risk.
How Much Are Prepayment Penalties?
Lenders calculate prepayment penalties in several ways.
Percentage of loan balance: Some lenders charge a percentage of your outstanding loan balance. For example, if you owe $100,000 and the penalty is 2 percent, you pay a $2,000 prepayment penalty.
Interest costs: Other loans calculate penalties based on how much interest the lender was going to earn if you kept the loan for the entire term. Calculations vary by lender and are often based on several months’ worth of interest. For example, a loan might require you to pay six months’ worth of interest if you refinance early.
Flat fees: Some lenders keep it simple. For example, Wells Fargo charges $500 for prepaying some home equity lines of credit (HELOCs) within three years.
How to Avoid Prepayment Penalties
You can dodge prepayment penalties in several ways. Waiting to pay off the loan is an easy solution, but you might not want to do that.
Keeping a loan might mean waiting to move and paying more interest than you need to.
Partial payment: Depending on your loan, you might be able to prepay a portion of your loan every year without facing penalties. For example, some lenders allow you to prepay up to 20 percent of your balance annually without any prepayment penalty.
Loan choice: It’s always wise to shop around before borrowing. If you’re in the market for a home loan, include government programs like FHA loans and VA loans in your search. Those loans do not feature prepayment penalties, but there are pros and cons to every type of loan.
Strategic waiting: Penalties can change over time—they might decrease or disappear entirely after several years. Learn how your loan works so that you can prepay when it makes the most sense to do so.
Sell instead of refinancing: Some lenders allow you to prepay without penalty when you sell an asset, but not when you refinance. Don’t just assume that every prepayment scenario will result in penalties.
After the 2008 mortgage crisis, the Dodd-Frank Act limited prepayment penalties on mortgages.
For most home loans issued after January 10, 2014, lenders can only impose prepayment penalties for the first three years of your loan, and the maximum penalty allowed is 2 percent. If you’re borrowing to buy a house, verify whether or not there is any prepayment penalty, and see if your loan falls under these rules—most loans do.
Lenders are required to provide consumers with clear information explaining the prepayment penalty.
This information should be easy to find on loan estimates and other disclosures, but some lenders are more helpful than others.
Other Types of Loans
For other loans, you need to read your loan agreements carefully. Prepayment penalties still exist on auto loans and business loans. On personal loans, they’re less likely, but you always need to read the fine print.
Student loans should not have any prepayment penalties. In the past, some private student loans came with penalties, but those penalties are no longer allowed after 2008.
Why Lenders Charge Fees
Why can’t we just live in a world without prepayment penalties? As you might imagine, lenders and investors don’t always appreciate when you pay off debts early. When issuing a loan, lenders plan to earn a profit and receive regular payments from your loan.
But when you prepay, you’re taking your ball and going home early. Lenders want to get that revenue one way or another.
Although it’s not always the case, sometimes it makes sense to choose a loan with a prepayment penalty (assuming you’re confident that you won’t pay early) over one that doesn’t have one. When you do so, you reduce risk for your lender, and that might encourage them to reduce your costs in return. However, this only works out if you have options—when you can compare the terms of loans with and without prepayment penalties and choose the best one.