What Is a Prepayment Penalty for Paying Off a Loan Early?

Quick Look

  • Some loans charge a fee a penalty to cover a loan off early.
  • Prepayment penalties are only legal on certain types of loans.
  • It’s possible to avoid prepayment penalties.

George’s beloved Aunt Azalea just died, leaving him a cash windfall large enough to pay his house off. But his wise friend William warns George about prepayment penalties, leaving George to wonder whether he should pay the house off or invest in an engagement ring for his latest lady love. 

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If you’re in the boat that is same George, you need to understand what a prepayment penalty is, where to find out if the loan has one, and ways to prevent them.

What Is a Prepayment Penalty?

A prepayment penalty is really what it may sound like — a penalty for paying down a loan early. On the loan that is overachieving mortgage rookies of the world, it may seem counterintuitive that a bank would want to charge you extra money for holding up your end of the bargain earlier than promised. But they lose out on a lot of interest you otherwise would have paid.

Not if you pay off your balance early all loans have prepayment penalties. In reality, they’re less today that is common ever before. But it’s crucial to know if your loan has one and what the details are before paying it off.Motley Fool Stock Advisor recommendations have an average return of 397%Sign Up Now

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How a Prepayment Penalty Works

A prepayment penalty comes into play when you try to pay a loan off, such as for instance home financing, in the first couple of numerous years of taking it out. Prepayment penalties can’t be a shock. They have to participate in the contract that is original signed when you took out the loan.

  • The Contract will outline the true period of time the prepayment penalty is active, usually as much as five, and exactly how much you must pay. There are lots of models lenders used to determine prepayment penalties.A set sum of money
  • , such as for instance $3,500A set amount of months’ interest
  • , such as for instance 6 months’ interestA percentage on the principal that is outstanding*), such as 2% of the remaining loan balance
  • A percentage of the outstanding principal on a sliding scale, such as 2% the first year,1.5% the next, and so on

That last one is the most common for mortgage loans, though you may come across the others when borrowing for other reasons. 

Types of Prepayment Penalties

There are two types of prepayment penalties, but the distinction primarily applies to mortgage loans.

  • Hard Prepayment Penalty. A prepayment that is hard is one you’ll pay any time you pay back the loan early regardless of what. Technically, you could potentially declare that all prepayment penalties on non-mortgages are difficult prepayment penalties. But this kind is just really relevant when making reference to mortgages, anyway.
  • Soft Prepayment Penalty. A prepayment that is soft lets you sell your home without a prepayment penalty but still charges it if you refinance. 

When to Worry About a Prepayment Penalty

If you’re new to the borrowing game, it probably sounds pretty easy to avoid paying off your loan for the first years that are few particularly if you’re referring to home financing, which typically has an expression of just one to 3 decades. Nonetheless it’s not that that is simple

Yes Until you get past the hurdle outlined in the prepayment penalty clause of your loan agreement.

But if you suddenly win the lottery but don’t want to make any changes to your living circumstances, you can avoid the prepayment penalty by just paying out the loan as promised, at least imagine if you’ve got an mortgage that is adjustable-rate like to trade in for a fixed-rate one before interest rates get out of control? What if the promotion to your swank job that is new selling your own house and thinking of moving yet another city?

To do either of the things, you need to pay back your original mortgage balance, potentially triggering the prepayment penalty clause.

Any time you need to do something that would need you to provide the bank a sizable payment that is lump-sum you should double-check to ensure a prepayment penalty isn’t involved. 

When Not to Worry About a Prepayment Penalty

  • If you have a loan you got prior to 2014, always worry about a prepayment penalty. Literally any loan you took out before that date is subject to old (read: less consumer-friendly) rules.
  • That said, in general, you usually (probably) don’t have to worry about a prepayment penalty as they typically expire by the fifth year at the latest 

    The payment you want to make is less than the specified amount or percentage you can pay in a lump sum without incurring a penalty

    • But check your contract no matter how old your loan or what you read on the internet if:You just make small extra principal payments here and there
    • You’ve had the loan for more than a few years. Only your contract can inform you what’s likely to happen along with your loan that is specific on Prepayment Penalties (for Post-2014 Mortgages, Anyway)
    • In 2014, The Consumer Financial Protection Bureau finalized the rules implemented under the Dodd-Frank Wall Street Reform and Consumer Protection Act. You may have heard (justifiably) negative things about its Wall Street “reform” aspect. But it did tighten consumer protections in some certain areas, specifically around prepayment penalties, that the bureau considers largely predatory, anyway.The big winners were homeowners-to-be. According to research by the bureau, your real estate loan is only able to have a prepayment penalty if all listed here are true:benchmark rateIt’s a mortgage that is fixed-Rate*). If the interest rate can’t increase as it meets the other criteria.

      It’s after you take out the loan, the bank can charge a prepayment penalty so long A mortgage that is qualified*). A mortgage that is qualified one with certain less-risky features that allow the borrower to settle the mortgage more quickly. 

      • It’s Not a mortgage that is higher-Priced*). Higher-priced mortgages are those with interest rates a percentage that is certain compared to the average prime offer rate, a
      • for mortgages. A jumbo loan is a good example of a mortgage that is higher-priced. 
      • Essentially, your mortgage has to be super-duper unrisky before the lender can add a prepayment even penalty.

      But it does not end there. As well as limitations on which forms of mortgages can have prepayment penalty even clauses, mortgage loans made after 2014 also have limits on the terms of prepayment penalties.personal loanMust expire after three years auto loanCapped at 2% of the balance that is unpaid the very first 2 yrs and 1% for all the third

      No-penalty options need to be available 

      • Note why these laws apply specifically to mortgages. Your
      • or
      • may have a prepayment still penalty. 
      • Also note that the law prohibits several types of government-backed loans from carrying prepayment penalty clauses. 

      VA loans backed by the Department of Veterans Affairs

      FHA loans backed by the Federal Housing Administration

      USDA loans backed by the Department of Agriculture

      Direct student loans backed by the Department of Education (though laws prohibit private student loans from charging prepayment penalties too)

      Noticeably absent from this list are Small Business Administration loans. Those could have prepayment penalties.

      However, these are just guidelines that are federal. Some states might have laws prepayment that is limiting too. For example, many states outright ban them. 

      But just because a bank does business in your state does mean your state’s n’t laws govern their activities. As an example, federal-chartered banks or credit unions may follow federal regulations rather than state ones. So always check.

      How to understand when your Contract Has a Prepayment Penalty

      Let’s just have it straightened out it’s coming: Read your contract because you know. Hire a lawyer to help you understand it it) if you have to (and can afford. However you should not sign any contract you really have read and understand n’t in full, word for legalese-y word, no matter how fine the print.

      That Said, the federal and maybe some continuing state governments have something called disclosure requirements. Those are legally mandated facts you must be told by a lender about your loan. It’s not enough to simply put it in the contract. They have to point it out somehow.

      There are two places they usually do so. First, you might find it within the loan estimate, that you get if your wanting to even sign the paperwork. But there’s also allowed to be a document that is separate may quite literally be labeled “disclosures.” Or it might be labeled TILA (for all the Truth in Lending Act) or something like that similar.official interpretationWhether it is your loan estimate or perhaps the disclosure form, it should include your rate of interest plus an accounting of any penny you need to pay or may need to pay various other fees. That’s the way that is easiest to find out if you have one. 

      Unfortunately it’s often confusing on the loan estimate or TILA form. And frankly, in this full case, I’m inclined at fault the form-maker: either the Federal Trade Commission or perhaps the Consumer Financial Protection Bureau, according to loan date and which type of loan you’ve got. 

      In the prepayment penalty section, example forms often say something like, “Yes, as high as $3,240 any time you pay back the mortgage in the first a couple of years.” However the form that is blank makes it look like a yes or no is fine by asking simply, “Does the loan have these features?” when talking about prepayment penalties and balloon payments.

      Mind you, the* that is( on the law says it is designed to explain at the least the max penalty. (Look under 37(b)(4), “prepayment penalty.”) But loan officers aren’t lawyers, together with sample forms through the national government make it seem like a yes-or-no question. Plus, you might have to know significantly more than the most penalty. So expect you’ll search for details within the contract that is long-form the disclosure documents don’t have them. They’re usually in the note that is promissory an addendum to it.

      And It, ask if you can’t find. The lender’s representative can point you to probably it pretty quickly. And they can be asked by you to update the loan estimate and TILA disclosure documents to include it.

      If it’s an loan that is established the lending company also needs to provide that info on any periodic statements it provides you with, such as for instance regular debts, the coupon book, or rate of interest adjustment notices.

      Side Note

      : there is the directly to take possession of a binding agreement and study it (and do whatever math you should do to evaluate the terms, including a prepayment penalty) before it is signed by you. 

      If a lender tries to pressure you into signing a contract without offering you enough time to read it privately or have an attorney review it, especially from leaving the premises with the contract, leave and find another lender.

      How if they try to prevent you to prevent a Prepayment Penalty

      Prepayment penalties are less frequent now than they was once. But mortgages that are pre-2014 some vehicle and personal loans may still have them. And it can almost pay literally) to prevent them — any time you discover how.

      Wait It Out

      If your loan has a prepayment penalty you don’t need to pay, you can wait it out. The prepayment penalty clause usually expires after a couple of years, as a result it’s not too long during the scheme that is grand of.

      So stay in the house, keep the car or let your kid buy it for only what you owe on the loan, or pay a loan off without a prepayment penalty instead. You’ll be able to circle back again to this package if the prepayment penalty clause expires.

      Pay Only a PortionCredibleSome loans with prepayment penalties still enable you to make large lump-sum payments when you don’t exceed a amount that is certain such as 20%. So pay off as much as you can without triggering the prepayment penalty. 

      That still reduces your balance that is outstanding and lessen your overall loan cost after a while, according to regards to the loan.

      Just Avoid It to begin with

      The way that is easiest to avoid a prepayment penalty is to avoid loan contracts that have them. If you apply.

      If the lender doesn’t have a loan without one or you don’t qualify for it, look for a different lender if you’re looking for a mortgage loan, remember that every lender that sells mortgages with prepayment penalties must have an option for a loan without a prepayment penalty it believes in good faith you will qualify for. It can save you yourself considerable time and hassle making use of loan the search engines like

      in the place of going straight to banks that are specific. You can get just as good a deal through a search engine without negatively impacting your credit score.And unless you have a relationship with a bank A loan with a prepayment penalty, you can always ask them to ditch it if a lender you’ve already gotten a quote from offers. They’ll probably say no, but you can ask. They might no less than have another loan product it is possible to check out. 

    • Just understand that they add prepayment penalties for an excuse, so expect the attention rate to move up. This may nevertheless be worth every penny when it comes to a mortgage you plan to sell your house or refinance sooner than later if you know. But you have to do the math to
    • If find out you have already plumped for that loan that includes a prepayment penalty, the thing that is only can do is avoid triggering it. That means knowing what the terms of the prepayment penalty clause are.Should You Get a Loan With a Prepayment Penalty? (if it means a lower interest rate*)If you know there’s no way you’ll pay off the loan early, a prepayment penalty isn’t so bad. However the future is not always very easy to predict, and you might be eligible for equally as good an interest rate without a prepayment penalty from another bank.

    Don’t get that loan with a prepayment penalty if:

    You intend to Refinance Soon

    • . Banks don’t just like their offers getting used as a stopgap until a greener is found by you pasture. It, it’s probably best to opt for a slightly higher interest rate than pay a prepayment penalty if you plan to refinance the loan within the first few years of getting. You Want To Sell Your Home Soon
    • . If you are planning to market your house soon, a prepayment penalty of 2% on the balance that is unpaid get pretty steep unless your penalty clause is a soft one.Early Payoff Is Important to Youdebt-to-income ratio. If paying off debt early is important and you think you’ll have the means to do so within a years that are few keep away from a prepayment penalty. Having said that, you could potentially always get a significantly shorter loan term instead. 
    • Should You Pay a Prepayment Penalty? (in some circumstances, such as:
    • You’d Save Money Overall*)If you’ve already signed on the dotted line and a prepayment penalty is inevitable if you pay off your loan now, paying the penalty may still be worth it. If you’d end up paying more in interest paying it off over time than you’d pay you may as well pay the penalty if you paid the penalty. 
    • You have to take Out a fresh Loan. Your

    is how debt that is much have versus your income. It’s one of the measures lenders use to determine your creditworthiness. You may need to pay down existing debt to do so if you’re looking to take out a new loan. If at all possible, pay back loans without any prepayment penalty first.  

    You need certainly to Save for Retirement

    . In the event the monthly loan payments are making a dent with what it can save you for retirement, it might be worth it to pay a prepayment penalty. The* that is( on investment accounts is between 7% and 10%, and also the magic of compound interest often means the essential difference between a miserly and comfortable retirement.

    • You Need to Avoid Going Upside-Down. Than it’s worth isn’t a desirable circumstance whether you call it upside-down or underwater, owing more money on your home or car. Avoiding it may You be worth it Want To Move — Now
    • . It probably doesn’t make sense to keep two housing payments if you have to move. You might be able to rent out your house that is original to the mortgage, but look at your mortgage contract for prohibitions on that too.Under Some circumstances, you might have to do the math to find out which one’s better for you. Sorry.

    Prepayment Penalty Examples

    Let’s say you took out a $200,000, 30-year mortgage that is fixed January 2022 at mortgage loan of 6.7%. It has got a prepayment penalty clause that assesses 2% off the third year.

    If if you pay it off within the first year, 1% if you pay it off within the second, and 0.5% if you pay it you decide to pay it off early, you’re going to owe quite a lot. But how much depends on how  much you still owe.

    First Year (2%)

    . Those high interest payments), and your prepayment penalty during the first year will be $3,960 in December 2022, you still owe $198,000 (gotta love. 

    Second Year (1%)

    . In 2023, you still owe $196,000 october. Your prepayment penalty is $1,960.

    Third Year (0.5%)credit mix. In 2024, you still owe $193,000, and your prepayment penalty is now just under $1,000 november.  

    If you’re trying to save cash if you are paying off of the house early, the prepayment penalty is normally significantly less than the attention pay that is you’d the next decade or three, at least if you bought your house after 2014. But if you’re refinancing or moving, it’s possible you’d have to get a much, much lower interest move or rate into a significantly cheaper house for any prepayment penalty to get worth every penny. So doing the math is essential. 

    Prepayment Penalty FAQs

    Thankfully, fewer loans may have prepayment penalties these days compared to years past. But it’s important to understand every aspect of how they work.How if you have a pre-2014 mortgage or opt for a loan type that can still legally have one Common Are Prepayment Penalties?

  • In the century that is 21st they’re pretty uncommon. Nevertheless they do exist, and so they might be more common if you’re still paying on an older loan.Does Prepaying a Loan Affect Your Credit Score? high-yield checking accountIt could, and not necessarily for the better.
  • For some people, prepaying a loan lowers their debt-to-income ratio, potentially improving their odds of qualifying for a loan that is new. Nonetheless it may come at a price by means of a short-term but very credit that is real hit. First, your

has a small but impact that is noticeable your credit. To obtain a credit that is healthy, you want a mix of installment credit like personal loans and mortgages and revolving credit like credit cards. There are more important aspects to your credit score, but if you’re teetering on the edge of very good and credit that is excellent it will make a significant difference within the rates of interest banks offer.

But potentially more significant will be the lost opportunity cost. A brief history of on-time payments is a much bigger element of your credit rating, therefore the faster you have to pay off the loan, the shorter that history becomes.

What Are the Alternatives to Prepayment?(with it:

Pay Off Higher-Interest Loans(*)*)If you’ve got a windfall of cash burning a hole in your pocket but prepayment would cost you money, there are several other things you can do. If you have higher-interest loans with no prepayment penalty, pay those off first. You’ll save more money over time. It’s tempting to pay your house off ASAP whenever you can, and when that will help you sleep during the night, do it now. However you may save money by paying down something else first.(*)Hold It(*). Put the cash into a (*), set it up to autopay your loan, forget about it then for a while. Set yourself a calendar reminder to test for anything else on it monthly to ensure your payment has come out and you aren’t out of cash, but don’t use it. Once the prepayment penalty clause expires, you can clear the account out and pay back your debt. You’ll earn a tiny bit cash that is extra your windfall to boot.(*)Invest It(*). With historical returns of around 10%, investing a larger sum of money, especially rather than paying off low-interest loans, could be a boost that is serious your retirement.(*)Final Word(*)Prepayment penalties don’t have for eating the money up you thought you were saving. But if doing the math on your options that are financial intimidating, it is possible to ask the mortgage officer from the bank for assistance doing any math you want for all the loan or loans they’re providing.(*)Otherwise, move to a (*). The U.S. Department of Housing and Urban Development offers a network of (*) who may be able to help if you have a low to moderate income. (*)

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