4 Things You Need to Know About Prepayment Penalties

what is a prepayment penalty

Just 27 percent of Americans currently carry no debt whatsoever, meaning that most of us have a loan or two that we are currently repaying. Mortgages, business, personal and auto loans can all come with prepayment penalties. Whether you’re signing on the dotted line for a new loan or figuring out a repayment plan for a current one, it’s important to get a grip on these fees.

What Is a Prepayment Penalty?

A prepayment penalty is a clause written into a loan agreement contract stating that if you pay off the loan early (either the whole amount or a substantial chunk of it), you’ll be liable to pay a fee. Often, the clause will only apply if you pay off the loan within a set period of time, such as within the first five years of a mortgage. Lenders write this clause into large loan agreements to ensure they don’t miss out on the interest they would have made if you’d paid the loan off gradually.

Not all loans carry prepayment penalty clauses—student loans taken out after 2008, for example, are exempt. But loans that come with the expectation that they will be paid over a certain period of time, such as 30-year mortgages or five-year auto loans, will commonly include this clause. These are called fixed-term loans.

How Much Will I Be Charged?

The amount you’ll end up paying varies greatly depending upon the provider and the amount you borrowed in the first place. But there are a few common ways that lenders will calculate the charge.

Flat Fees

Some loans come with a flat fee for paying off the balance early. For example, Wells Fargo will charge you $500 for paying off a home equity line of credit within three years of taking out the loan.

Part of the Loan Balance

Your provider could charge you between 2% and 5% of the loan balance. For example, if you owe $100,000, you could end up paying between $2000 and $5,000.

Percentage of the Interest Due

Some providers will charge you part of the interest that you’ve dodged by paying off the loan early. For example, you could be asked to pay 80 percent of six months’ worth of interest.

What You Should Know About Your Mortgage Prepayment Penalty

If you took out your mortgage anytime from January 10, 2014 onward, your provider will only be allowed by law to charge a maximum of 2 percent and only within the first three years of your mortgage. Lenders are also supposed to make information about mortgage prepayment penalties clear and easy to locate on your estimate.

How to Avoid Paying Prepayment Penalties

Of course, it makes sense to shop around for a loan that doesn’t come with a prepayment penalty, but that isn’t always possible. There are several ways you can avoid paying the fee.

Wait it Out

As most penalties are tied into a particular time such as the first five years of the loan, a good option can be to wait until the fixed term has passed. Calculate the interest you’d pay during that remaining period and compare it to the penalty you’d be liable to pay.

Consider Selling

If you sell the car or home for which you originally took out the loan, some providers will let you pay off the balance without paying the penalty. Check the terms with your lender.

Increase Your Payments

Paying out the loan in full may result in a penalty, but you may be able to increase the amount you pay to speed up the process. Your lender could let you repay up to 20% of the remainder of the loan a year, which means you could pay off your balance in as little as five years.

To make sure you are able to take out loans under the best possible terms, maintaining a decent credit score is essential. SmartCredit can help you control your future score with a range of easy-to-use tools—from a customized 120-day plan of action, to a gamified dashboard to achieve your best possible score.

References:

  1. https://www.cnbc.com/2018/08/20/how-much-debt-americans-have-at-every-age.html
  2. https://www.investopedia.com/terms/p/prepaymentpenalty.asp
  3. https://www.thebalance.com/prepayment-penalty-the-basics-315632
  4. https://www.nolo.com/legal-encyclopedia/when-are-prepayment-penalties-allowed-new-mortgages.html
  5. https://www.forbes.com/advisor/mortgages/prepayment-penalty-what-it-is-and-how-to-avoid-one/
  6. https://loans.usnews.com/articles/what-is-a-loan-prepayment-penalty#:~:text=The%20penalty%20for%20mortgages%20may,charge%20a%20flat%20dollar%20amount.
what is a prepayment penalty

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