If you're able to pay off a loan earlier than required, you deserve a huge pat on the back. But before you make a move, it's critical to know if your lender will penalize you for early repayment.
Lenders make their money by charging interest on loans. If a borrower pays off the loan far earlier than their term, the lender makes less money. To discourage this early payoff, some lenders charge a prepayment penalty—a fee that's charged only if a borrower pays off their loan early. While many loans don't have these fees, you may come across them in some personal loans, auto loans, mortgages and lines of credit.
Prepayment Penalty Costs
These days, it's typically easy to find financing without prepayment penalties, especially with personal loans. You're more likely to find these penalties with mortgages or auto loans, where the lender is at risk of losing a substantial amount with early repayment. If you encounter a prepayment penalty, here's how much you might expect to pay.
Mortgages
Under the latest federal laws, most new mortgages can't have prepayment fees. If they do, they're only levied on conventional mortgages, and only if the mortgage is paid off within the first three years.
If you took out a fixed-rate mortgage loan after January 2014, your lender is only allowed to charge a prepayment penalty of up to 2% of the outstanding balance if you pay it off within two years. If you pay it off during the third year, the lender can charge up to 1%, but after three years, they can no longer issue a fee.
Also, note that mortgage lenders that do charge a prepayment fee are required to also offer an alternative loan option without one.
Auto Loans
In over half of the U.S. states, auto loan lenders are allowed to charge prepayment penalties for loans of 60 months or less. If your loan term is 61 months or more, your lender cannot charge you a prepayment fee.
But if you do encounter an auto loan with prepayment penalties, you'll typically pay around 2% of the outstanding balance.
Prepayment Penalty Example
So how much would a prepayment penalty actually cost you?
Since these fees are typically a percentage of the outstanding balance, the amount varies greatly depending on the size of the loan. It's always worth crunching the numbers to see whether your savings would be greater by paying off the loan early and stomaching the fee, or waiting to avoid the fee.
Here are two examples:
Example 1: Auto Loan
Let's say you have a 60-month car loan with a 2% prepayment penalty.
You are halfway through your term with an outstanding balance of $10,000 when you receive a windfall and want to pay off the remainder of the loan to save on interest. Your prepayment fee would be $200 for paying off the loan ahead of schedule.
To determine if it's worth it, calculate how much interest you'd pay over the remaining life of the loan if you didn't pay it off early. If it's more than $200, then you're saving money. If it's not, it may be better to wait.
Example 2: Mortgage Loan
Imagine you took out a mortgage just under two years ago. Your outstanding balance is $200,000, when you see mortgage interest rates drop dramatically and you want to refinance.
Refinancing to a new loan requires your first loan being repaid in full, but your lender charges a 2% fee for prepayment within the first two years of the loan term. This means you'll pay a $4,000 prepayment penalty to pay off your loan, as well as any fees associated with refinancing.
If you can wait until the third year, when the fee goes down to 1%, you'll owe $2,000. And since lenders can no longer charge prepayment penalties after three years, it may be best to wait until three years pass so you don't have to pay a fee, unless your interest savings on the new loan would outweigh the cost.
How to Avoid Prepayment Penalties
All lenders are legally required to disclose if they charge a prepayment penalty. Here are some ways to potentially avoid this fee, depending on where you are in the loan process:
- If you're still shopping around: At this stage, avoid applying for financial products that charge a prepayment fee. As you compare options, carefully review the terms and conditions of loans on each lender's website, look for a clause about prepayment and check to see if their fee schedule shows a charge for early repayment. If you can't find the information, contact the lender to ask if they charge this fee.
- If you've already applied: If a lender has approved you for a loan but you haven't yet signed and agreed to the terms, pause to carefully review the disclosures. If you find a prepayment penalty, you can either choose to not move forward with that loan or opt to not pay off early unless the math works in your favor. You can also ask for a loan option without a prepayment fee (which might have different terms), or try to negotiate with the lender to remove the fee altogether.
- If you already have the loan: Check your loan agreement to see if your lender charges a prepayment penalty, and contact your lender if you can't find it. If your loan does have this fee, find out how it's charged and do some calculations to see whether the fee would negate interest savings from early repayment. You can also look for ways around it; for example, many mortgage lenders don't assess a prepayment penalty if you pay off up to 20% of the outstanding balance each year, so making larger payments over time can bring down the balance without incurring a fee.
Keep Your Credit in Mind
Don't forget that your loan activity makes a huge difference in your credit score. Paying off a loan can help since you have less outstanding debt, but it can also reduce your credit mix and alter your average age of accounts. Losing this means of establishing a regular repayment history can also have an impact, especially if you don't have other loans or credit cards showing responsible repayment.
Carefully consider any potential credit implications before repaying a loan prematurely, and consider signing up for free credit monitoring from Experian to stay on top of any changes.