Why Prepayment Penalties Make Paying Off a Loan Early More Expensive

Planning to make an early loan payoff? Ask about prepayment penalty fees first.

You would think a lending institution would be happy to get its money back early, but that’s not always the case. Believe it or not, you can be charged a penalty fee for paying off a personal loan early. Some banks and finance companies charge a fee to borrowers who pay off their personal loans before the end of the loan term.

If you have the opportunity to throw extra money at a loan and pay it off, find out first if your lender charges a prepayment penalty fee. Lenders charge these fees to mitigate prepayment risk, which means that if the borrower pays the loan off early, the lender will be deprived of future interest payments.

Understand how prepayment penalties work, so you can avoid paying more money than necessary.

What Is a Prepayment Penalty?

Prepayment penalties, also known as exit fees or prepay fees, are additional costs that a lending institution charges the borrower if he chooses to pay off his loan before the term ends. Different types of loans have different prepayment rules. Mortgage lenders, for example, typically allow homeowners to pay off a certain percentage, such as 20 percent, of their remaining mortgage balance per year before charging a prepayment penalty. Lenders charge prepayment penalties because it enables them to place the loan in a security and sell it; because another institution might buy that security, it will need assurance that the loan will be outstanding for a set period of time, which means the buyer will expect a certain yield from that security.

A prepayment penalty will change depending on the amount of the loan. The penalty amount is calculated by multiplying the remaining amount on the loan by the prepayment penalty. Take, for example, a $100,000 loan with a 3/2/1 exit, which means you pay an amount when you close the loan to reduce the interest rate over the first three years of its term. So, your interest rate will be 3 percent lower the first year than the permanent rate, 2 percent lower the second year and 1 percent lower the third. If you want to repay in two years instead of the agreed-upon three-year loan term, assuming it’s an interest-only loan, the exit fee would be $2,000.

Related: 7 Things to Consider Before Paying Off Your Mortgage Early

Hard vs. Soft Prepayment Penalties

You might hear two different terms when it comes to prepayment penalties: hard prepayment penalties and soft prepayment penalties. Soft prepayment penalties occur only when you refinance or take out a new loan, usually leading to longer terms and lower interest rates. A hard prepayment penalty, on the other hand, is charged when the borrower pays off the entire loan balance early or, in some cases, refinances.

Rule of 78

The rule of 78 is a method commonly used by lenders in which interest payments are weighted more heavily toward the beginning of the life of the loan, so borrowers who pay off loans early pay more than those who pay off the loan over the life of the loan term. Along with prepayment penalties, the rule of 78 further disincentivizes early loan payoff. The rule of 78 is typically used for consumer loans such as car loans. The rule of 78 cannot be legally applied to loans with terms longer than five years, such as mortgages.

Learn: Why Paying Off Your Auto Loan Early Doesn’t Always Save Money

How to Avoid a Prepayment Penalty

Although prepayment fees definitely work in favor of lending institutions, clearly they don’t benefit borrowers. You might not even think to ask about exit fees when you sign your loan documents, which could later prove to be a costly mistake if you’re planning an early loan payoff.

It’s critical that you evaluate the total cost of the loan you’re taking out, which includes quite a few loan fees. The lender fee, or the loan origination fee, is a fee that the lender charges for simply making the loan; it’s typically calculated as a percentage of the loan amount. Keep in mind that the origination fee could be steep, so make sure your lender is competitive with his figure. Other fees might include inspection, appraisal and broker charges. Exit fees, if they apply, are part of the total cost of the loan — so count them in, too.

When you sign on the dotted line for your loan, if you don’t see the phrase “no prepayment penalty” anywhere in the contract, it’s likely you’ll have to pay one. Your state laws might dictate the lender provide you with advance notice of such penalties before you sign, but don’t count on it — and do your research.

Related: Worst Fees in America — And How to Avoid Them

Slow Down Before Signing

Don’t get overwhelmed by all the documentation you’ll have to go through to get a loan. Take the time to read the fine print and you might save yourself a big headache in the long run.

If you’re negotiating loan terms, ask if there’s a simple-interest contract with no prepayment penalty available. And always shop around and compare offers from a variety of credit unions and banks. Taking these steps will not only ensure you get the best loan available to you, it will enable you to pay off your loan early without getting stuck with unexpected fees.

Laira Martin contributed to the reporting for this article.