What Is a Loan Prepayment Penalty?

Paying off your loan early can save you hundreds or even thousands of dollars in interest, but if your loan has a prepayment penalty, you may get stuck with a fee.

Thanks to federal legislation, prepayment penalties are less common than they used to be. In fact, many mortgages don’t have a prepayment penalty attached to them. But some loans, including some mortgages, can have prepayment penalties. So it’s important that you know whether yours does and what to expect if that’s the case.

[Read: Best Mortgage Lenders.]

What Is a Prepayment Penalty?

Prepayment penalties are fees that some lenders may charge to borrowers who pay off part or all of their loan earlier than what is stated in the terms of the loan agreement.

Some borrowers reduce their interest costs by making extra-large payments on the mortgage, often with the goal of eliminating the loan entirely within a shorter time frame.

“The earlier you pay off the loan, the less you’re going to pay in interest,” says Michael Sullivan, a personal financial consultant with Take Charge America. “So the less the loan is going to cost you, and the less the house is going to cost you.”

Other borrowers may pay off the loan early because they are selling their home or refinancing into a new mortgage.

Prepayment penalties should never come as a surprise to the borrower. A lender cannot assess a prepayment penalty unless the penalty was included in the original terms of the loan. In other words, the borrower has to agree to this stipulation when accepting the loan terms.

“Prepayment penalties are limited to specific loan types. And even then, buyers must be given a nonprepayment option. They’re never required,” says Dan Green, CEO at Austin, Texas-based Homebuyer.com.

Why Do Lenders Charge Prepayment Penalties?

While prepaying a loan is almost always a good thing for the borrower, it is not so great for the lender. When a borrower pays off a loan early, it robs the lender of months or years of interest that the lender otherwise would collect on the loan.

“Remember that lenders make money by loaning you money,” says Cynthia Meyer, a fee-only certified financial planner with Real Life Planning in Gladstone, New Jersey. “The interest you pay on your mortgage or loan is the lender’s revenue. The outstanding principal is an asset on the lender’s books.”

For this reason, some lenders use prepayment penalties to discourage you from paying off your mortgage early. The longer it takes you to pay off your home loan, the more money the lender collects in interest.

“The lender charges a prepayment penalty to create a disincentive to repay the full loan balance early,” Meyer says. “For a mortgage lender, this disincentivizes borrowers from refinancing a loan quickly in periods of declining interest rates.”

[Read: Best Mortgage Refinance Lenders.]

Which Loans Carry Prepayment Fees?

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act added new requirements for mortgage creditors and servicers, including stricter guidelines regarding prepayment penalties.

After the act became law, the Consumer Financial Protection Bureau was tasked with implementing the new rules. As a result, since 2014, prepayment penalties are prohibited for certain types of mortgages.

According to the Federal Register, Dodd-Frank Act provisions “generally prohibit prepayment penalties except for certain fixed-rate qualified mortgages where the penalties satisfy certain restrictions and the creditor has offered the consumer an alternative loan without such penalties.”

FHA, VA and USDA loans cannot have prepayment penalties.

For lenders that do charge these penalties, prepayment penalties cannot be imposed after the first three years of the loan term.

Student loans do not carry prepayment penalties, although some personal loans and business loans may, depending on the lender.

How Much Do Prepayment Penalties Cost?

There are limits as to how much your lender can charge you in prepayment penalties.

During the first two years of the loan, prepayment penalties cannot be more than 2% of the outstanding loan balance or more than 1% of the outstanding loan balance during the third year of the loan. Your lender determines how much you will pay in prepayment penalties. The exact amount may vary by lender.

One of the most common methods of charging a prepayment penalty is a sliding scale, determined by the length of your mortgage. For example, if you pay off the mortgage in the first year of the loan, you might owe 2% of the remaining principal balance on the loan. Wait until the second year to pay off the loan, and you might owe a penalty equivalent to 1% of the mortgage balance.

Some lenders might simply choose a percentage of the overall loan balance and use that as a prepayment penalty fee in all cases.

“Lenders may also charge a fixed penalty or a certain number of months of interest,” Meyer says.

What Are the Benefits of Prepaying a Loan?

Prepaying a loan can save you hundreds or thousands of dollars in interest costs. And because you are paying less in interest, the loan is going to cost you less.

“So basically, if you prepay a loan, you are saving money on the cost of the home,” Sullivan says.

Paying off your mortgage frees up money in your budget that otherwise would go toward making your monthly loan payment.

“When you’ve got to pay for your kid’s college or you’ve got to save for retirement, you’ll have extra cash because you’ve made those prepayments on the house,” Sullivan says.

Should You Take a Loan With a Prepayment Fee?

Sullivan says that for most people, it likely does not make sense to take a loan with a prepayment penalty attached.

“The benefits would have to be significant enough to absorb the risk,” he says.

Even if you carefully weigh the pros and cons, the risk of taking on a prepayment penalty still can end up bigger than it initially appears. For instance, you may plan to stay in your home for three years or longer after you purchase it, thereby avoiding any chance of getting hit with a prepayment penalty. But things can change.

“Nobody knows for sure how their health is going to be, or the health of family members, or job situations or major catastrophes,” Sullivan says.

Such risks underscore the potential downside of taking on a prepayment loan.

Meyer says there may be some situations where accepting a prepayment penalty might make sense, especially if “you are willing to accept the prepayment penalty risk in return for a lower interest rate.”

However, you may find that weighing the pros and cons of the lower rate against the prepayment penalty makes such a loan look less attractive than it appears at first blush. “It doesn’t make sense for everyone,” Meyer says.

Green says loans with prepayment penalties are not a good deal for consumers and adds that he believes it never makes sense to take a loan with a prepayment penalty.

“Prepayment penalties are consumer-unfriendly,” he says. “Find a better option.”

How Do You Avoid Loan Prepayment Penalties?

It is crucial that you understand your loan terms and whether any prepayment penalties might apply. Knowing what is in your contract — and which actions can lead to a prepayment penalty — is crucial to avoid triggering one of these fees.

“When a prepayment penalty exists, its trigger is when the loan is paid off in full through a home sale or refinance,” Green says. “Some loans with prepayment penalties also trigger when the homeowner pays down its balance by 20% or more.”

By law, lenders must disclose if they charge prepayment penalties and how they do so.

“You have to agree to a prepayment penalty when you purchase the home or investment property,” Meyer says. “It doesn’t magically appear after the loan is closed.”

Carefully read the loan estimate and other paperwork and make sure you understand what you are getting into before you sign any documents, as terms can vary from lender to lender. Also note if there are any special situations where prepayment penalties might be suspended.

“It’s common for prepayment clauses to have exceptions to the penalty if the home is sold,” Meyer says.

If you are unsure about the terms, ask your lender if prepayment penalties are part of the loan and to show you where the relevant details are in the paperwork.

Some lenders explicitly advertise as a perk that their products don’t charge prepayment penalties, so if you’re trying to avoid the risk of paying this fee, you might consider applying with one of those lenders.

When Is a Prepayment Penalty Worth the Cost?

There is almost never a good time to pay a prepayment penalty, Green says. But there are situations where you might not have a choice.

“When you have to sell, you have to sell,” he says. “In times like that, all options stink.”

So, you may have to pay the penalty to move on with your life in such circumstances.

Meyer says that paying a prepayment penalty can make sense if you run the numbers and find that refinancing to a lower rate still saves you money even after taking the prepayment penalty into account. Another situation where paying the penalty can pay off arises when you have a highly appreciated property and want to take cash out for another property purchase, which Meyer says is a common strategy in rental property investing.

More from U.S. News

How to Pay Off Your Mortgage Faster

When Does Paying Off a Personal Loan Early Make Sense?

How Do Loans Work?

What Is a Loan Prepayment Penalty? originally appeared on usnews.com

Update 02/18/22:

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