The Truth About Prepayment Penalties

Suppose you have some extra cash and you want to start paying back more than the minimum monthly payment on your loan so that you can reduce the debt quicker. Sounds good in theory, but sometimes there may be consequences for paying off a loan early.

This is known as the prepayment penalty, and it’s a deterrent that lenders use to prevent borrowers from paying off a loan early. The reason? Because the lenders are making money each month on the interest you are paying. If you begin paying off the loan early, that means you are paying less interest, which means less cash for the lender. Obviously, they don’t like that, so to offset any loss, they impose a penalty for paying off a loan early.

Sometimes, this can actually wind up costing you more that you would have normally paid had you just made your regular monthly payments! (Related: 3 Misconceptions About Student Loans.)

A flat rate penalty requires you to pay a specific, pre-determined amount as a fee for paying off the loan early. For example, the fee may be six months worth of interest on a three-year loan.

A percentage penalty requires you to pay a percentage of your remaining balance, and a reducing penalty is a fee that reduces itself during the length of the loan. For example, the penalty at the beginning of the loan may be 3%; but over time, it can be reduced to 1%, meaning that if you pay off a three-year loan about a year early, you will be required to pay a 1% penalty on the remaining balance.

Not all loans have prepayment penalties, but not all lenders will let you know about them either. Whenever you are seeking any sort of loan from a lender, it is always wise to ask about any prepayment penalties right from the start so that you can make an informed decision and there are no surprises later.