What is a prepayment penalty?

Applying for a loan to buy a house, car or other personal investment is a big decision—so you want to understand exactly what you’re agreeing to before you sign. The terms and conditions of a loan should spell out the interest rate, repayment period and whether there’s a prepayment penalty.

A prepayment penalty is a fee charged for paying off the loan before the payoff date you’ve established with your lender. Learn more about how this penalty works and ways you might be able to avoid one.

Key takeaways

• A prepayment penalty is a fee that lenders charge for paying off a loan early.
• Prepayment penalties don’t apply to all loans, so it’s important to read the terms and conditions to see if you’d have to pay one.
• Lenders calculate prepayment penalties differently, and there are ways to avoid any surprise fees.

When you take out a loan, the lender expects to earn money from that loan through interest and fees. So if you pay off the loan early, the lender loses money on the interest they would’ve earned if you paid it according to the original payment schedule. A prepayment penalty is meant to discourage you from paying too quickly and ensures the lender still earns money if you do.

The 2010 enactment of the Dodd-Frank Act—which protects consumers from financial corruption—changed the rules of how prepayment penalties can be charged to borrowers. As a result, prepayment penalties are prohibited for high-priced, adjustable rates and nonqualified mortgages.

Some of the practices that make a mortgage not subject to prepayment penalties include:

• Loans that put borrowers at risk: Balloon payments, negative amortization and interest-only loans can put borrowers in jeopardy of defaulting on their loans. 
• Excess fees or high annual percentage rates (APRs): With a nonqualified mortgage, there are no protections or limits on what a lender can charge.
• No income verification: Lenders that don’t verify your income and assets to be sure you can afford the loan may be putting you at risk.

A qualified mortgage means the lender did their due diligence to make sure borrowers have the ability to repay their loan. For qualified mortgage loans, prepayment penalties can be implemented for the first three years. For the first and second years of the loan, a penalty of up to 2% of your mortgage balance can be charged, and the third year penalty may be up to 1%. After that, prepayment penalties are prohibited. You may want to check your loan’s fine print for the exact prepayment penalty terms.

Lenders might calculate prepayment penalties in one of several ways based on the loan terms. Here are a few ways prepayment penalties can be calculated:

• Cost of interest: To determine the interest cost, the lender looks at what interest would be owed if you paid the loan off in the set time frame. For example, if a 10-year loan was paid off in eight years, the lender might charge a prepayment penalty for the remaining two years of interest.
• Percentage of loan balance: In this case, the lender would take the total balance owed on the loan and charge a percentage of that. For example, a balance of $50,000 with a 2% prepayment penalty could mean a $1,000 penalty to pay it off early.
• Flat fee: Although this prepayment penalty typically may not apply to mortgages, lenders may apply a flat fee for other loans. For example, a car loan might have a $300 flat fee as a prepayment penalty.

When you start searching for any loan, it helps to do your homework. You could talk with the lender and ask whether they charge prepayment penalties. Also read the loan documents thoroughly—and don’t sign anything you don’t completely understand. Pay close attention to any additional fees and penalties for an early payoff, even if it’s to sell or refinance the loan.

Here are a few tips that can help you avoid any prepayment penalty surprises:

• All loan products are different, so take the time to shop around and find the loan that will help you achieve your goals. 
• Talk with a lender about the terms you want and let them help you find the right loan.
• A good credit score may give you better loan terms and mortgage rates.

If you’re considering a loan with a prepayment penalty clause, it can be helpful to crunch the numbers in case you decide to pay it off early. It may still be worth it, but if not, you’ll understand the loan terms before you sign.

Before you sign any loan agreement, you’ll want to fully understand the details of the loan. By taking time to ask questions and read the terms carefully, you can know whether you’ll be subject to a prepayment penalty.

Although paying off a mortgage early might seem like a good idea, you can evaluate your options and decide what’s best for you. Learn more about how to save money while paying off debt.