At a Glance

When it comes to different loan types, hidden fees can be disguised in the contract terms. These fees can quickly add up and make the cost of taking on a loan not worth the hassle. This is why identifying any such fees early on is so crucial. A prepayment penalty is one such fee that will sometimes be added to the contract terms and is a fee that can be quite costly.

Prepayment penalty personal loan

Before diving into the several types of prepayment penalties that can exist, let’s quickly cover what exactly a prepayment penalty is. In short, it is a fee that a lender may charge a borrower if they completely pay off their loan early. This fee is usually a set percentage that is determined at the time of signing the loan.

It is worth noting that prepayment penalties are most common with mortgage loans, though not all mortgage loans will have one. Understanding the way, a prepayment penalty works can help you avoid the fee, though to understand this you must have knowledge of how loan repayment works. There are a few key parts to a loan:

  • Principal: A loan principal is the sum being borrowed, which often includes the amount of interest owed.
  • Interest Rate: This is an additional amount of money owed on top of the pure amount borrowed, determined by an agreed upon percentage
  • Repayment Period: The repayment period is the total amount of time a borrower must pay back the loan
  • Repayment Amount: This is the amount owed monthly.

A prepayment penalty occurs when a borrower either pays back the entire loan earlier than the total repayment period or pays more than a certain percentage back in a year. In many cases, lenders are more than willing to allow you to make extra payments on a loan but exceeding the set amount will result in a fee.

The reason for this fee is that when a borrower pays off a loan early, a lender loses out on the interest that would have been paid on the rest. The purpose behind a prepayment loan can vary depending on the type of loan.

Prepayment penalty mortgage loan

The general idea of a prepayment penalty on a mortgage loan is the same as a prepayment penalty on a personal loan, however, the purpose can change. Lenders will often add a prepayment loan onto a mortgage loan to safeguard against early refinancing or a home sale in the first couple of years after the purchase.

An early payoff penalty legally needs to be disclosed by a lender before signing, but it’s also a good rule-of-thumb to ask a lender about any existing fee early in the purchasing process. There are two distinct types of prepayment fees regarding mortgage loans:

  • Soft Prepayment Fee: A soft prepayment fee is when a homeowner is allowed to sell their home without taking a fee, but refinancing the home will be grounds for paying a fee
  • Hard Prepayment Fee: On the other hand, a hard prepayment fee does not allow a homeowner to sell or refinance without paying the fee

The only type of mortgage loan that does not have a prepayment fee is a Federal Housing Authority loan. It is also worth noting that prepayment penalties on conventional mortgage loans started becoming less common after the housing crisis of 2008, but they do still widely exist today.

Business loans, car loans, and personal loans may all have prepayment penalties associated with them, but it varies lender to lender. As for personal loans, there are many lenders online who do not charge prepayment penalties, and it is best to track down these lenders rather than settling for one who charges you a fee.

Regardless of the type of loan you seek, always talk with your potential lender about fees and the terms of a loan. It is incredibly important that you understand all the parts of a loan that exist when you sign the contract.

FAQs

Is there a prepayment penalty on student loans?

Under federal law, lenders are not allowed to charge prepayment fees on any educational loans. This has been banned in the U.S. since 1965. Paying off student loans early can be both a profitable and smart idea for anybody who is financially capable. While prepayment penalties on student loans are banned, other loans can have prepayment penalties, so it is important to ask a lender about associated fees.