What Are Prepayment Penalties?

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Paying off a loan early may sound enticing, and it certainly can be beneficial. You'll lower your debt load and reduce the amount of interest you pay over the life of the loan.

But because early loan repayment also means less revenue for lenders, some charge a fee to make up for those losses, called a prepayment penalty. While these fees are less common now than they once were, here's where you may still find them and how to avoid them.

What Is a Prepayment Penalty?

Installment loans come with a set term; for example, five years to pay off a personal loan, or 30 years to pay off a mortgage. The monthly payments are calculated so your balance will be paid off at the end of the loan term.

Lenders typically allow you to add extra to your monthly payments or additional payments during the year, which can help you pay off your balance faster. In fact, lender Rocket Mortgage says most lenders allow customers to pay off up to 20% of their balance each year without a penalty.

However, some lenders charge a prepayment penalty if you pay off your loan before the term ends. The types of loans that are allowed to carry prepayment penalties, and the amount lenders can charge, were restricted by the 2010 Dodd-Frank Act but still exist for some types of loans, including certain mortgages. If your mortgage comes with a prepayment penalty, it must be noted in the loan agreement you sign when you close on your home, according to the Consumer Financial Protection Bureau (CFPB).

Prepayment penalties most often occur when borrowers pay off their mortgage within a certain time frame, such as three or five years, according to the CFPB. The same goes for home equity loans and lines of credit: While prepayment penalties aren't always in the agreement, when they are, the fee is usually triggered when the loan is fully paid off several years early.

If a personal loan or other loan type comes with a prepayment penalty, it must also be disclosed in the loan agreement along with other fees, such as origination fees. With any type of loan, it's important to ask the lender directly whether there is a prepayment penalty: The existence of such fees can be buried in the fine print of your loan documents, so it's best to find out before you're getting ready to close on a loan. When a loan does have this fee, ask the lender how it's calculated since methods and costs can vary. Prepayment penalties are not permitted on student loans.

Why Do Lenders Charge Prepayment Penalties?

Lenders make their money on loans by charging borrowers interest. With each loan payment, a portion of your money goes to your loan principal and a portion goes to the lender as an interest payment.

Interest rates on loans are calculated partly based on the loan term. If you decide to pay off a loan years early, the lender loses out on interest revenue they anticipated for that time period. To mitigate this loss, they might charge a prepayment penalty to discourage early repayment or to guarantee they recoup some of the money if a loan is paid off early.

How to Avoid Prepayment Penalties

There are two primary ways you can avoid paying prepayment penalties on loans:

  1. Avoid loans that have them. 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. Some lenders explicitly advertise that they don't charge prepayment penalties as a benefit, but if there's no obvious wording about it, review the fine print and fee table. If you're unsure whether the lender charges this fee, ask them directly.
  2. Stay within the parameters. If you find yourself in a position where the lender you want to use 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.

Be Mindful of Credit Implications

Managing an installment loan such as a personal loan, mortgage, car loan or student loan responsibly can help your credit scores. Not only does it contribute to your credit mix if you don't have any other installment loans, but it gives you an opportunity to demonstrate regular on-time payments over a long time period.

Once the loan is paid off and noted as closed on your credit report, its payment history is weighed less heavily in your credit score than active accounts. You may also have a potentially a less diverse credit mix, which could ding your score. This may be less of a concern than saving hundreds or thousands of dollars in interest, however, and continuing to manage your other credit accounts responsibly will keep your credit in good shape over the long haul. If you're paying off a loan early, consider enrolling in free credit monitoring from Experian to keep an eye on how it impacts your credit score over time.