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
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:
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:
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:
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.
How do I know if my loan has a prepayment penalty?
To determine if your loan has a prepayment penalty, you can ask your lender and read the terms and conditions to understand exactly what they involve.
Can I negotiate with the lender if I don't like the loan terms?
You can talk with the lender to try to negotiate better terms. It might help to get everything in writing and read the loan documents thoroughly before you sign.
Will paying off a loan early hurt my credit?
Any time you make changes to your credit, you may want to consider how it affects your credit score. Since credit-scoring companies calculate credit scores based on factors like your credit utilization and payment history, paying off a loan may have a temporary negative effect.
How can I get help with understanding my loan's terms?
The Consumer Financial Protection Bureau has resources available to help you understand the mortgage and loan processes. It might also be worth talking to a financial adviser.
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.