Prepayment Penalty

Prepayment Penalty
A prepayment penalty is a fee charged by lenders when borrowers pay off their loan before the end of the term.

What is a Prepayment Penalty?

Prepayment penalties are fees charged to borrowers for paying back their loans early. Typically, they don’t apply to individual payments—they are only charged when a borrower pays off a loan in its entirety.1 These types of fees are occasionally found in personal loans, but they more frequently occur in mortgage contracts. A mortgage is an installment loan used to purchase a home, where the home serves as collateral.

Why do lenders charge Prepayment Penalties?

Because lenders make money on interest, they’ll earn more money the longer it takes a borrower to pay off their loan. Imagine if a borrower were to pay back a loan as soon as they received it. The lender wouldn’t make any money at all. That’s why, to protect their investment, lenders will try to discourage borrowers form paying the loan back too quickly. By attaching a fee to early repayment, the lender is assuming that the borrower is less likely to pay their loan back early, and that even if they do, the lender will still be making a profit.

Why would someone pay off their mortgage early?

Theoretically, you might suddenly win the lottery or inherit a fortune that allows you to pay off your entire mortgage immediately. Far more commonly, however, you’ll want to pay off the whole mortgage because you’ve sold the house that was being used as collateral. Ideally it’s because you’re moving somewhere else you’d rather be, though of course there are less fortunate circumstances in which someone might have to sell their home.

How much are Prepayment Penalties?

The amount of a prepayment penalty depends on the lender and varies greatly. It tends to be a percentage of the total cost of the loan. It might be a fixed amount or it might change based on how long you’ve been making payments on the mortgage. So if there’s a fixed 4% prepayment penalty on a $100,000 mortgage, you would have to pay $4,000 when you pay back the loan early, whether you do so one month in or one month from when you were supposed to finish paying it off. Other prepayment penalties might become lower as time goes on, with a 4% penalty the first year you have the mortgage, a 3% penalty the following year, and so on.2

How do I know if my loan has a Prepayment Penalty?

Unfortunately, many lenders will not be forthcoming about prepayment penalties, which can lead to a nasty surprise down the line. That’s why it’s important to carefully read your loan agreement. Prepayment penalties might be hidden, but they must be stated, so if a loan contains a prepayment penalty, it will be noted in the agreement.3 One type of major installment loan, student loans, should not have any prepayment penalties. That’s because a law passed in 2008 prohibits it.4 Still, you’re always better off reading the fine print. The best way to avoid a bad contract is not to sign it at all.

What is the difference between soft and hard Prepayment Penalties?

Unlike hard prepayment penalties, a soft prepayment penalty isn’t activated just by paying off your loan early. Soft prepayment penalties are only paid when you refinance, or take out a new loan, normally with a longer payment term and better interest rates. Hard prepayment penalties are paid whenever you pay off your entire loan early or when you refinance.5

How can I avoid Prepayment Penalties?

Feel free to directly ask the lender, and always read your loan agreement carefully before signing it. If the loan has a prepayment penalty, consider looking elsewhere. Many socially responsible lenders—including OppLoans—do not charge them.

References:

  1. “Prepayment Penalty.” Investopedia. Accessed on October 6, 2016, at http://www.investopedia.com/terms/p/prepaymentpenalty.asp.

  2. Peterson, Erin “6 Steps to a Lower Prepayment Penalty” Bankrate,com. Accessed on February 3, 2017, at http://www.bankrate.com/finance/mortgages/6-steps-to-a-lower-prepayment-penalty-1.aspx

  3. “Can I prepay my loan at any time without penalty?” Consumer Financial Protection Bureau. Accessed on October 6, 2016, at http://www.consumerfinance.gov/askcfpb/843/can-i-prepay-my-loan-any-time-without-penalty.html.

  4. “Higher Education Opportunity Act. U.S. Congress. Accessed on February 3, 2017 at https://www.congress.gov/110/plaws/publ315/PLAW-110publ315.pdf.

  5. “Understanding Hard and Soft Prepayment Penalties.” Homeloanbasics.com. Accessed on February 3, 2017 at http://www.homeloanbasics.com/articles/PurchasingAHome/UnderstandingHardandSoftPrepaymentPenalties/.