What Is a Prepayment Penalty?

What Is a Prepayment Penalty?

A prepayment penalty is a fee some lenders charge when you pay off your mortgage, auto, personal or another loan early. That's because your payments, including principal and interest, are calculated so your balance will be paid off at the end of the loan term. When you pay off your loan ahead of time, the lender misses out on your future interest payments. As such, some lenders add prepayment penalties to their loans to incentivize borrowers to pay their loans as agreed instead of early.

Prepayment penalties are typically incurred when you pay off your mortgage within a specific time frame, such as three or five years. The same goes for home equity loans and lines of credit. Applying extra cash toward your principal payments periodically usually won't trigger a prepayment penalty, but check with your lender to be certain.

Lenders are required to disclose when they charge a prepayment penalty. When you get a mortgage, this information should be listed in your loan estimate and, ultimately, in your closing loan documents. You can typically find this fee in the disclosures or addendums.

Types of Prepayment Penalties

There are two types of prepayment penalties: soft prepayment penalties and hard prepayment penalties.

• Hard prepayment penalty: You could incur this type of penalty fee if you sell your home or refinance your mortgage. You might also face a prepayment penalty if you pay down your loan balance by 20% or more in a year.
• Soft prepayment penalty: You might pay a penalty fee only when you refinance, but not when you sell your house. So, if you sell your home and use the proceeds to pay off your mortgage, you won't incur any penalty fees. On the other hand, your lender may charge a prepayment penalty if you refinance your loan, depending on your loan terms.

Before refinancing a mortgage with a hard prepayment penalty, run the numbers to make sure you'll come out ahead. Consult your loan documents or talk with your lender to confirm the fees you'll pay and assess whether the savings from the new loan outweigh the penalty fee.

Why Do Lenders Charge Prepayment Penalties?

As mentioned, lenders impose prepayment penalties to mitigate the loss of interest payments for the loan's full term. Remember, your lender is exposed to the most risk during the first few years of your loan term. That's because, in most cases, your down payment is only a small percentage of the home's value. Consequently, lenders lower their risk—and generate a profit—by charging you mortgage interest.

However, when paying off your loan in the early years of your term, the lender misses out on these interest fees and, by extension, their profit. As such, lenders charge prepayment penalties to encourage you to keep your loan long enough for your lender to profit or recoup their losses if you pay off your loan early.

How Much Does a Prepayment Penalty Cost?

As with other loan costs, prepayment penalty fees vary from lender to lender. Where one lender charges a fixed amount, another might charge a percentage of your loan balance. If your loan includes a prepayment penalty, it may resemble one of the following fee structures.

• Balance percentage: With this penalty fee, your lender charges you a specific percentage of your remaining loan balance. If your contract lists your penalty fee as 2% of your outstanding loan balance, and you sell your home when its balance is $300,000, then your prepayment penalty would be $6,000.
• Interest penalty: In some cases, lenders charge a penalty fee equal to the loan's interest for a specific number of months. For example, if your lender charges a 12-month interest penalty and your monthly interest payment is $400, you would have to pay $4,800 ($400 x 12 months) if you pay off your loan early.
• Scaled fee: Some lenders impose a fee that adjusts depending on how many years are left on the loan. Some of the most common examples include the 3/2/1 and 2/1 prepayment penalties. In the former's case, you would pay 3% of your outstanding loan balance if you pay off your mortgage in the first year. The penalty fee drops to 2% in the loan's second year, 1% in the third year and is eliminated after that. So, if your home has a $300,000 balance and you pay it off in the third year, you'd pay a $3,000 prepayment penalty fee. Similarly, a 2/1 prepayment penalty charges 2% of your remaining balance in the first year, and 1% in the second.
• Flat fee: This type of fee is less common than the others but is pretty straightforward. Your loan documents may specify a fixed prepayment penalty amount, such as $3,000, to pay off your loan ahead of schedule.

How to Avoid Prepayment Penalties

There are a few ways you can avoid paying prepayment penalties on loans:

• Avoid loans that charge prepayment penalties. Not all lenders charge prepayment penalties, so when you're comparing personal loans, mortgages or any other type of financing, take a close look at the terms and fees and select an option that doesn't carry a prepayment fee. If you're unsure whether your loan charges prepayment fees, refer to your loan documents in the fee and addendum sections or ask your lender directly.
• Stay within the parameters. If you want a loan that charges a prepayment penalty, find out exactly how and when the penalty kicks in, and plan to work around it. For example, if your mortgage lender allows repayment of up to 20% of the balance annually before charging a fee, make some calculations to keep your extra payments below that threshold and avoid triggering a prepayment penalty. Along the same lines, you might consider putting off refinancing or selling your home until after the penalty period ends—typically three years.
• Negotiate a prepayment penalty waiver. If your loan includes a prepayment penalty, negotiate with your lender to waive or reduce the fee. Your lender may be willing to work with you, especially if you have other accounts with them. If your lender agrees to remove the fee, get it in writing just to be safe.

Frequently Asked Questions

• Does Prepaying a Mortgage Affect My Credit Score?

  Paying off your mortgage early shouldn't have a significant impact on your credit scores. Your mortgage will remain on your credit reports for up to 10 years, so your average age of accounts and credit mix, which account for 15% and 10% of your FICO^® Score^☉ , respectively, shouldn't change. If you don't take out another mortgage within those 10 years, those factors could come into play and cause your credit score to dip slightly. But if you've consistently paid your debt accounts on time, your credit score may be higher in 10 years and offset any minor drop.

• Should I Pay Off My Mortgage Early?

  Paying off your mortgage early can save a significant amount on interest, but you should still run the numbers to make sure you're coming out ahead. If you're within your loan's first three years, it may be best to hold off a bit before paying off the mortgage to avoid the prepayment penalty. Or you may decide to pay the prepayment penalty if selling your home or refinancing leads to significant interest savings or a lower interest rate. Also, if the prepayment penalty period has passed, paying off your mortgage to eliminate years of interest payments may make sense.

The Bottom Line

Fortunately, prepayment penalties on mortgages and other loans are becoming less common. With a little effort you should be able to find a lender that doesn't charge this fee on its loans. If your current loan charges a prepayment penalty, make sure selling or refinancing your home would save you in the long run before making a move.

Having good credit can help you qualify for credit and loans with the most favorable terms and features—saving you more in interest. Before applying for a new loan, check your credit report and credit score for free with Experian to see where your credit stands and address any issues you find on your report. Also, consider signing up for free credit monitoring to help you stay on top of your credit.