What is a prepayment penalty and how can you avoid it?

Prepayment penalties are exactly what they sound like — fees for paying off all or some of your loan early.

In the world of personal finance, paying off a debt before you’d planned is usually a cause for celebration.

But when you pay off your loan sooner than expected, your lender doesn’t earn as much interest. By listing a prepayment penalty on the loan, your lender can either try to discourage you from paying off the loan early (resulting in full interest payments) or make up for “lost” interest by charging you the fee.

Keep in mind that these fees only affect you if you pay off your loan early — they won’t affect you if you pay off the loan as scheduled in your contract. But it’s always a good idea to know if the loan you’re signing up for charges a prepayment penalty — even if you don’t plan to pay the loan off early. Knowing the terms of your loan can help you make financial decisions in the future.

We’ll discuss where you might run into prepayment penalties, how to avoid them and what to do if you already have one in your contract.

• Are prepayment penalties always legal?
• Loans that might have prepayment penalties
• Types of prepayment penalties
• How to avoid prepayment penalties
• How to deal with prepayment penalties on an existing loan
• FAQs about prepayment penalties

Are prepayment penalties always legal?

If you think prepayment penalties sound like trouble, you’re not alone. In fact, the Consumer Financial Protection Bureau deemed them a risky loan feature. In 2014, the agency implemented rules to restrict how much lenders can charge in prepayment penalties on certain mortgages.

Some states go so far as to ban prepayment penalties on all types of loans. But some banks are regulated by federal law, not state law, so it’s important to do your research and talk to your lender so you know which policies apply to your loan.

Loans that might have prepayment penalties

You may come across prepayment penalties in a number of different types of loans.

Mortgages

If you do see a prepayment penalty, it’s most likely on a mortgage loan. While it has become less common since the 2008 housing crisis, some mortgage loans still come with these fees, which can add up to thousands of dollars. Not all mortgages have them, but if yours does, you likely agreed to it in your closing documents.

Typically, you won’t be charged a prepayment penalty when you put small chunks of extra money toward your loan principal. But if you pay off a large part of your balance at once, or pay off the entire balance within the first few years (even if it’s due to selling or refinancing your home), you may owe the lender a prepayment penalty.

The actual cost of a prepayment penalty varies by lender. The fees can either be calculated as a percentage of the principal balance remaining on your mortgage, or as a lump sum. Some states also have laws that place additional time and financial limits on these fees.

Other loans

Prepayment penalties are less common on other types of loans, but it’s possible you’ll encounter them at some point. For instance, certain auto loans come with a prepayment penalty clause.

Some personal loans may have these fees as well, though many personal loan lenders specifically advertise that they don’t have these fees. You might also come across a prepayment penalty on a home equity line of credit, or HELOC.

Take note: Lenders are not allowed to charge you a prepayment penalty if you pay your student loans off early. Additionally, federal credit unions aren’t allowed to charge prepayment penalties on any loans (although state-chartered credit unions can charge them on certain loans, provided the state allows it).

Types of prepayment penalties

There are two types of prepayment penalties for home loans — one can be more forgiving than the other. Be sure to talk with your lender about which type of prepayment penalty they may use

Soft prepayment penalty

With a soft prepayment penalty, you’re able to sell your home without having to pay a penalty. But if you’re planning on refinancing with a soft prepayment penalty, you’ll have to pay a prepayment penalty.

Hard prepayment penalty

A hard prepayment penalty can occur if you sell your home before the end of your loan term or if you refinance your mortgage.

How to avoid prepayment penalties

If your mortgage has a prepayment penalty, it should be in your loan estimate, and later, your closing documents. Keep your eyes peeled for this fee in the disclosures — it may be hidden in an area called the “Addendum to the Note,” so be sure to read it along with anything that says “addendum.”

If your auto loan or personal loan has this penalty, your contract is required to include it so that you’re notified before you sign on the dotted line. It should be in the Truth in Lending disclosures, so read those closely. And keep in mind that you can always try to negotiate the fee away.

If you are offered a loan with a prepayment penalty, ask the lender for a quote on a similar loan without one so that you can compare options. For certain mortgages, you have the right to receive an alternative offer without a prepayment penalty if you receive an offer with a prepayment penalty. If you don’t see an option you like, you can always get quotes from another lender.

If there’s a prepayment penalty in your prospective loan contract and you can’t seem to avoid it, ask the lender these questions before you sign to learn exactly how it works.

• In what exact circumstances do I have to pay the penalty?
• Does it apply to partial payments or only full payment? If partial, how much can I pay off before the fee is triggered?
• In the case of a mortgage, does it apply if the home is sold or refinanced?
• How much is the fee?

There are some loans that don’t allow prepayment penalties like FHA, VA and USDA loans.

How to deal with prepayment penalties on an existing loan

Do you have a loan, but are unsure if it includes a prepayment penalty clause? If you have a mortgage, check your closing documents, monthly billing statements and any interest rate adjustment documents. If you’re not able to track down this information, ask your lender.

Did you already sign on a loan with a prepayment penalty? Unfortunately, if it’s in your contract, you can’t make it go away. But you can find out what actions will trigger the penalty and do your best to avoid them.

Talk to your lender and find out the exact details of the prepayment penalty. Then run some basic numbers to find out what you’ll owe if you pay off the loan early or refinance it — and whether that move will save or cost you money in the long run.

FAQs about prepayment penalties