Learn what a prepayment penalty is, how much it can cost, and how to avoid paying this fee for paying off your loans early.
Loans come with terms and conditions that outline things like how much you’ll pay in interest, how long you have to make payments (also known as the loan term), and what fees or other extra costs might apply to your loan.
If you are taking out a loan, it’s important to understand what fees like this are and how they work. You might have to pay fees like this or you might be wondering how to avoid prepayment penalties.
Keep reading and we’ll go over what prepayment is, what a prepayment penalty is, how it works, and how you can avoid this fee.
What Does Prepay Mean?
When you prepay something, that means you paid ahead of time or before the payment was actually due.
If you prepay for a movie ticket, that means you went online and paid for the movie tickets ahead of time, before arriving at the ticket booth.
You can prepay loan payments as well. When you prepay a loan payment you are making that loan payment before the scheduled due date. When you prepay an entire loan, you are paying off the entire loan balance all at once, before the end of the loan term.
Prepaying a loan payment doesn’t usually come with any penalty fees. But sometimes, paying off the total loan balance before the end of the loan term can come with a prepayment penalty.
What is a Prepayment Penalty?
A prepayment penalty is a fee a lender might charge when a borrower pays off a loan balance early. Not all lenders charge this fee, but if you want to pay off your total loan balance early, then it’s a good idea to check for this fee first.
The reason this fee sometimes exists is because lenders receive profit from a loan from that loan’s interest. This accumulation of interest is essentially what the borrower pays for the ability to borrow the principal balance.
When a borrower pays off a loan early, this interest doesn’t get the chance to accumulate and pay the lender for allowing you to borrow the principal. To ensure lenders still receive a payment for the amount borrowed, they will sometimes charge a prepayment fee.
How Much is a Prepayment Penalty?
How much you pay for a prepayment penalty depends on your lender and the loan you have with them. If you want to pay off your loan early, the best thing to do is to call a loan representative at your lender and ask how much your prepayment penalty might be.
A lender might calculate this fee in a few ways:
- A percentage of the remaining balance
- The interest for a certain number of months
- A fixed fee amount
- An amount based on the length of the loan term
Many lenders might charge between 1-2% of your loan balance as a prepayment fee. For example, let’s say you take out a $1,000 loan and pay it off early. This prepayment fee would then cost $10-20.
How to Avoid a Prepayment Penalty
To avoid paying a prepayment penalty, first, check with your lender to learn whether they charge this fee or not. If they do charge it, ask about the terms surrounding this fee and what needs to happen for this fee to be applied.
By learning about how their fee works, and what exactly needs to happen for it to get applied, you can learn how to avoid it.
Make Larger Payments. For example, instead of paying off the entire remaining balance all at once, you could instead make larger payments to pay it off much quicker. Depending on the terms of this fee, this could help you successfully avoid paying the fee while still paying off your loan sooner.
Pay Off After the Fee Period. Some fees will only be applied if you repay the loan in full before a certain amount of time. For instance, you might be charged a fee if you pay off a 5-year loan in the first 2 years, but you might not be charged if you pay it off after this 2-year period is over.
You can also avoid a prepayment fee by always reading our loan agreement carefully before you sign. That way, you can see that there is a prepayment fee and potentially choose a different loan provider instead.
States That Don't Allow Prepayment Penalties
Some states don’t allow prepayment penalties for certain loans, so if you’re in one of those states, you might not need to worry about this type of fee.
For example, Alabama, Alaska, and Illinois don’t allow prepayment penalties for first mortgages that have an interest rate over 8%. Look into your state’s regulations on this fee for the type of loan you want to learn for yourself.
Prepayment Penalty on Car Loans
If your state doesn’t allow this fee on mortgage loans, they might still allow a prepayment penalty on car loans. When researching about this fee for your state, make sure you keep this in mind if you are interested in a car loan or title loan.
Prepayment Penalty on Personal Loans
If your state doesn’t allow this fee on mortgage loans, they might still allow a prepayment penalty on personal loans. When researching about this fee for your state, make sure you keep this in mind if you are interested in an installment or personal loan.