What Is A Loan Prepayment Penalty & How Does It Work?

What Is A Prepayment Penalty?

A prepayment penalty is a cost charged by lenders to borrowers who pay off all or part of their debts early. These costs are specified in loan agreements and are permitted in specific loan types, such as conventional mortgages, investment property loans, business and personal loans. Fees normally begin at 2% of the outstanding principle amount and gradually decrease to zero during the first few years of a loan.

Prepayment penalties may be inconvenient for those seeking to pay off debt or create equity in their home. You may frequently avoid these penalties by avoiding specific kinds of loans, paying off your loan after the fees phase out, or negotiating directly with your lender before closing on a loan.

Prepayment penalties are prohibited under federal law for several forms of house loans, including FHA and USDA loans, as well as student loans. In other circumstances, lenders may levy early payback penalties, although there are time and cost constraints imposed by federal law.


How a Prepayment Penalty Works

It’s not realistic to expect most individuals to repay a loan within a year or two after taking it out. But a lot of individuals refinance their loans to take advantage of a cheaper interest rate or if their credit improves. Prepayment penalties may make it more costly to refinance during the first three years after taking out a loan.

Prepayment penalties vary by lender and loan type. It’s possible to find a lender that won’t impose any fees, but other institutions may place limits on what you may borrow. When prepays are levied, they’re only charged for the first few years of a loan, following which they phase out—usually within three to five years.


Someone signing a contract

Prepayment Penalty Costs

If you repay your loan within the first year, the prepayment penalty is normally roughly 2% of the outstanding sum. Some loans have larger fines; however, many loan types have a maximum penalty of 2%. Penalties then decrease with each year of the loan until they reach zero.

Prepayment penalties are normally charged on the outstanding sum at the moment the loan is paid off early.

Many prepayment clauses also allow borrowers to pay off up to a specified proportion of their mortgage (often 20%) without incurring a charge. Prepayment penalties may not be a problem if you wish to make additional payments in the early years of your loan without refinancing or paying it off fully.

Prepayment penalties are only applied to specific kinds of loans, but they are always included in loan documentation, which is why it is critical to read disclosures before accepting a loan offer.


Prepayment Penalty Example

Assume Susan is a new homeowner who has just purchased her first home. To finance her purchase, she took up a $400,000 30-year mortgage at 4% with a prepayment clause. The condition calls for a sliding scale of early payment penalties for the first five years of the loan.

Susan’s credit score has improved two years after she took her loan, interest rates have dropped, and she wants to take advantage and refinance the $385,000 left on her loan. She finds another mortgage lender that would refinance her new loan at 3.25% for 15 years. Overall, refinancing will save her $325 a month, but she will have to pay a $5,775 prepayment penalty (or 1.5% of her outstanding loan debt) when she pays off her existing loan.

Susan would repay her penalty in a little more than two years (after closing fees are factored in) via savings from her new loan in this scenario. If she intends to stay in her home for at least three or four years, refinancing and paying the penalty may be a good idea. If she believes she will be moving within the next year or two, she should continue with her previous loan.


Why Do Lenders Charge A Mortgage Prepayment Penalty?

You could assume that whomever borrows money to your will want to get it back as quickly as possible. Lenders take on more risk at the beginning of a loan term than borrowers do. That’s because most borrowers haven’t made a down payment that comes close to covering the cost of the property outright. That is why lenders charge you “interest,” which is a kind of insurance against financial loss. They counted on collecting interest payments from you as compensation for lending you money, but when you pay off the loan early, they don’t get any of that money.


How Do I Check For A Prepayment Clause?

The good news is that lenders are required by law to disclose prepayment penalties, as well as monthly fees and other loan information. As previously said, you should study the “fine print” – in this instance, the loan estimate or the papers that you’ll sign at closing, where it will be clearly mentioned in the addendums and/or disclosure documents along with all the other conditions of your business loan.

It’s acceptable to ask your lender whether they impose a prepayment penalty; if they do, ask them to show you where you may discover the information in the paperwork. If you already have a loan, you should be able to see it on your monthly billing statement.

You might attempt to negotiate a reduced cost if you decide to continue with your lender and the loan with the penalty. You may always attempt to get it deleted from the contract; or inquire with your lender if they would waive the cost. If they agree (which is uncommon but always worth a shot), get it in writing. You may also get a quotation from your lender without incurring any penalties, but keep in mind that doing so may result in an increase in your interest rate.


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