How to Avoid Paying a Prepayment Penalty

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A number of factors go into deciding where to get a loan for a house, a car or a big purchase. Among other things, you need to consider the lender's interest rate and the amount of time you'll be given to pay off the loan. But there's another factor you should pay attention to: prepayment penalties.

In some cases, lenders charge fees if you pay off a loan before the loan term ends. These are known as prepayment penalties, and they can be costly. But if you understand how they work, you might be able to avoid them altogether.

What Is a Prepayment Penalty?

Prepayment penalties don't apply to all types of loans. Loans that may come with prepayment penalties include mortgages, auto loans and personal loans. For instance, let's say you took out a 48-month auto loan but want to pay it off in 40 months. Some lenders might charge a prepayment penalty for this early payoff, while others might not.

Why do some lenders charge a prepayment penalty for certain loans? It's simple: If you pay off your loan early, the lender won't reap as much interest from your loan. So, some lenders impose prepayment penalties to discourage borrowers from paying off the balance earlier than initially agreed.

Prepayment Penalties for Mortgages

Government-backed mortgages such as Federal Housing Authority (FHA), U.S. Department of Veterans Affairs (VA) and U.S. Department of Agriculture (USDA) loans do not come with prepayment penalties, but conventional mortgages frequently do. You might find that you'll even face a prepayment penalty if you refinance your mortgage, which replaces your existing loan with a new loan. A lender might also charge a prepayment penalty if you pay a big chunk of your mortgage at one time.

Most mortgage lenders let you pay as much as 20% of your loan balance each year without fear of any penalty. But if you decide to pay off the entire balance all at once, you could be penalized. For instance, let's say you pay off the $250,000 balance on your mortgage and the prepayment penalty on your loan is 2%. In this case, you'd have a prepayment penalty of $5,000.

It's worth noting that your state might limit the prepayment penalties for mortgages. For example, Massachusetts doesn't allow a lender to charge a prepayment penalty if a mortgage is paid off at least 36 months after the loan was taken out.

Prepayment Penalties for Other Loans

Thirty-six states and Washington, D.C., let auto lenders charge prepayment penalties for loans with terms of 60 months or less. Lenders are prohibited by law from charging a prepayment penalty for an auto loan of 61 months or longer.

As for personal loans, some lenders charge prepayment penalties, but many do not. You can check whether a personal loan lender charges prepayment fees with Experian CreditMatch™ after logging in to your Experian account, or by going directly to the company's website.

Federal and private student loans let borrowers do early payoffs without prepayment penalties.

How Can You Find Out if a Loan Has a Prepayment Penalty?

When you're rate shopping for loans, find out if any loans you're considering carry a prepayment penalty by simply asking the lender or looking on the company's website. If there's a good chance you may pay off the loan early or, in the case of a mortgage, refinance or sell your home before the term is up, this is especially important. Lenders must disclose this information to you when you are closing on a loan, but it's better to find out ahead of time and use the information to help you weigh which loan will work best for you.

At the very least, check your loan contract's Truth in Lending disclosures before signing. There you'll find the specifics on whether you can pay off your loan early without paying a fee as well as your loan's interest rate, the amount financed and other important details. Read this fine print carefully.

Ways to Avoid Prepayment Penalties

There are several ways to avoid prepayment penalties when you are getting a loan. They include:

  • Shopping around for a loan that doesn't charge a prepayment penalty.
  • Asking a lender to give you an estimate for a loan that doesn't include a prepayment penalty.
  • Negotiating with a lender to eliminate the prepayment penalty for a loan you're considering or one you already have.

If you already have a loan that carries a prepayment penalty, it might be cheaper to pay the prepayment penalty rather than continuing to make loan payments, including interest. Be sure to do the math to see how that scenario will play out.

In addition, letting a mortgage lender include a prepayment penalty in your loan agreement might lead to a lower interest rate. That arrangement could end up saving you money over time in the form of interest payments. Also, if your credit isn't great, a mortgage lender might be more willing to give you a home loan if you agree to a prepayment penalty. Before you do, find out the exact details of any prepayment penalties. For example, some mortgages may waive the fee if you are selling your home, but the charge may still apply if you simply refinance it.

How Are Prepayment Penalties Calculated?

Prepayment penalties are calculated in several ways. They include:

  • Flat fee: Some lenders will charge a prepayment penalty as a flat fee. So, regardless of when you pay off the loan, the fee will be the set amount, such as $120 for a personal loan, spelled out in your loan agreement.
  • Interest cost: Let's say you've got a 10-year loan and decide to pay it off at the nine-year mark. A lender might hit you with a year's worth of interest payments as a prepayment penalty.
  • Percentage of balance: A lender might opt to charge a prepayment fee that is a percentage of the remaining loan balance instead of the interest cost. For a mortgage, the penalty could be 1%, 2% or more.

The Bottom Line

Regardless of which type of loan you're seeking, it's always smart to check your free credit score and report from Experian to get a better idea where your finances stand. If your score could use improvement, consider taking time to improve your credit history before applying for a loan.