What is a Loan Prepayment Penalty?

What is a Loan Prepayment Penalty?

Loan prepayment penalties are charged to borrowers who pay off their loans early. These penalties are commonly associated with mortgages and auto loans, and can often end up costing borrowers thousands of dollars. Because lenders need to make money off of their loan, many charge prepayment penalties as a way to recoup the money they would have made on long-term interest. Prepayment penalties are not charged for FHA mortgages, student loans and some business loans.

Prepayment Penalties by Type

Loan prepayment penalties are common fees that lenders charge borrowers to discourage early termination of a loan agreement. This is because lenders make a substantial portion of their loan profits on interest payments, and paying off a loan early eliminates this income stream for the lender. Penalties are usually calculated by multiplying a predetermined percentage by the loan's outstanding balance at the time of termination.

Are Prepayment Penalties Allowed?
  • Yes for conventional mortgages
  • No for FHA loans
Auto LoansIn certain states
Student LoansNo
Personal LoansYes
Business LoansYes

For the consumer, it's important to consider whether the benefits of paying off your loan early are worth making a prepayment penalty. If you have a smaller loan amount, it might be a smarter financial move to pay down your loan in normal installments rather than take the prepayment penalty. By paying off your loan over the whole term, you'll also build credit. However, if you're looking to refinance or want to put your year-end bonus towards paying down your home or car, the prepayment penalty could be worth it.

Mortgage Prepayment Penalty

Some conventional mortgages come with prepayment penalties if you pay them off within the first few years. Terminating a mortgage early is common among savvy homebuyers, so lenders charge these fees to protect themselves from losing money when a borrower wants to refinance or sell their home. Borrowers who do choose to refinance can often times include the cost of the prepayment penalty in their new loans. To find out if your loan has a prepayment penalty, check your loan agreement and any "Addendum" documents.

Fortunately, some states put caps on how much lenders can charge for prepayment. Additionally, the federal government bans lenders from charging prepayment penalties on FHA mortgages. If your mortgage does have a prepayment penalty, it will generally cost about 2% of 80% of the loan's principal. For example, on a $200,000 loan, the prepayment would cost 2% of $160,000, which is $3,200.

Auto Loan Prepayment Penalty

Auto loan prepayment penalties vary depending on lender and state, with roughly 70% of states allowing these fees. Penalties are commonly assessed on loans under 48 months. However, across the US they are banned on loans longer than 60 months, or 5 years. In general, it's smart to take out an auto loan with a term of 48 months or shorter—the value of cars quickly depreciates, and it's common for borrowers with longer terms to find that they owe more on their loan than their car is worth.

To avoid getting stuck in a loan with early payment fees, find an auto financier that will provide a simple-interest loan—one where repayment consists of fixed monthly principal and interest payments. These loans are the most straightforward and tend to have the least added costs. In all cases, you should closely read the fine print to check for hidden fees. Particularly for borrowers with poor credit, it's important to make sure that the loan you're getting is affordable as advertised.

Student Loan Prepayment Penalty

Private and federal student loans have no prepayment penalties. This enables borrowers to pay down their balance early, either by making the occasional large monthly payment or by paying down the balance in one sum. If you plan to put extra payments towards your student loans, it's important to communicate with your loan servicer about how you want the excess money to be used. If you have multiple loans, it's a good idea to put a little extra money towards the loans with the highest interest rates first.

Personal and Business Loan Prepayment Penalties

The terms of personal loans and business loans vary widely, but lenders are allowed to assess prepayment penalties in most cases. As with the other loan products, it's important to check the terms of your specific agreement before making any extra payments. If you're unsure whether your loan has an early exit fee or how much it will be, you can always contact your lender to find out.

Yowana is a former product analyst at ValuePenguin, specializing in credit cards, rewards programs and travel. He previously covered mortgages, banking and insurance for the website. Yowana graduated from Columbia University with a B.A. in Political Science.