I
% What Is a Prepayment Penalty for Paying Off a Loan Early? Skip to content
visibility
995 views
thumb_up
29 likes
R
Learn how to make it. Explore
Manage Money
You've got it.
thumb_up
40 likes
N
Learn what to do with it. Explore
Save Money
You have it.
thumb_up
18 likes
N
Make sure you have some later too. Explore
Spend Money
You're spending it.
thumb_up
33 likes
A
Get the most for it. Explore
Borrow Money
You're borrowing it. Do it wisely.
thumb_up
8 likes
A
Explore
Protect Money
You don't want to lose it. Learn how to keep it safe. ExploreInvest Money
You're saving it.
thumb_up
40 likes
B
Now put it to work for your future. Explore
Categories
About us
Find us
Close menuWhat do you want to do br with money
Popular Searches
Learn more about your money
Make Money
You need it. Learn how to make it.
thumb_up
11 likes
L
Explore
Manage Money
You've got it. Learn what to do with it. ExploreSave Money
You have it.
thumb_up
35 likes
B
Make sure you have some later too. Explore
Spend Money
You're spending it. Get the most for it.
thumb_up
19 likes
A
Explore
Borrow Money
You're borrowing it. Do it wisely.
thumb_up
8 likes
J
Explore
Protect Money
You don't want to lose it. Learn how to keep it safe. ExploreInvest Money
You're saving it.
thumb_up
11 likes
C
Now put it to work for your future. Explore
Categories
About us
Find us
Close menu Advertiser Disclosure Advertiser Disclosure: The credit card and banking offers that appear on this site are from credit card companies and banks from which MoneyCrashers.com receives compensation.
thumb_up
17 likes
D
This compensation may impact how and where products appear on this site, including, for example, the order in which they appear on category pages. MoneyCrashers.com does not include all banks, credit card companies or all available credit card offers, although best efforts are made to include a comprehensive list of offers regardless of compensation.
thumb_up
0 likes
N
Advertiser partners include American Express, Chase, U.S. Bank, and Barclaycard, among others.
thumb_up
28 likes
O
Borrow Money Loans
What Is a Prepayment Penalty for Paying Off a Loan Early?
By Heather Barnett Date November 09, 2022FEATURED PROMOTION
Quick Look
Some loans charge you a penalty to pay off a loan early.Prepayment penalties are only legal on certain types of loans.It’s possible to avoid prepayment penalties. George’s beloved Aunt Azalea just died, leaving him a cash windfall large enough to pay off his house.
thumb_up
31 likes
E
But his wise friend William warns George about prepayment penalties, leaving George to wonder whether he should pay off the house or invest in an engagement ring for his latest lady love. If you’re in the same boat as George, you need to know what a prepayment penalty is, how to find out if your loan has one, and how to avoid them.
What Is a Prepayment Penalty
A prepayment penalty is exactly what it sounds like — a penalty for paying off a loan early. To the overachieving loan or mortgage rookies of the world, it may seem counterintuitive that a bank would want to charge you extra money for holding up your end of the bargain earlier than promised.
thumb_up
16 likes
K
But if you pay off your balance early, they lose out on a lot of interest you otherwise would have paid. Not all loans have prepayment penalties.
thumb_up
44 likes
B
In fact, they’re less common today than ever before. But it’s crucial to know if your loan has one and what the details are before paying it off.
Motley Fool Stock Advisor recommendations have an average return of 397%.
Motley Fool Stock Advisor recommendations have an average return of 397%.
thumb_up
9 likes
N
For $79 (or just $1.52 per week), join more than 1 million members and don't miss their upcoming stock picks. 30 day money-back guarantee. Sign Up Now
How a Prepayment Penalty Works
A prepayment penalty comes into play when you try to pay off a loan, such as a mortgage, within the first few years of taking it out.
thumb_up
50 likes
B
Prepayment penalties can’t be a surprise. They must be part of the original contract you signed when you took out the loan. The contract will outline the number of years the prepayment penalty is active, usually up to five, and how much you must pay.
thumb_up
33 likes
E
There are several models lenders use to determine prepayment penalties. A set amount of money, such as $3,500A set number of months’ interest, such as six months’ interestA percentage of the outstanding principal, such as 2% of the remaining loan balanceA percentage of the outstanding principal on a sliding scale, such as 2% the first year,1.5% the next, and so on That last one is the most common for mortgage loans, though you may come across the others when borrowing for other reasons.
Types of Prepayment Penalties
There are two types of prepayment penalties, but the distinction primarily applies to mortgage loans. Hard Prepayment Penalty.
thumb_up
40 likes
H
A hard prepayment penalty is one you’ll pay if you pay off your loan early no matter what. Technically, you could say that all prepayment penalties on non-mortgages are hard prepayment penalties. But this type is only really relevant when talking about mortgages, anyway.Soft Prepayment Penalty.
thumb_up
22 likes
A
A soft prepayment penalty lets you sell your home without a prepayment penalty but still charges it if you refinance.
When to Worry About a Prepayment Penalty
If you’re new to the borrowing game, it probably sounds pretty easy to avoid paying off your loan for the first few years, especially if you’re talking about a mortgage, which typically has a term of one to three decades. But it’s not that simple. Yes, if you suddenly win the lottery but don’t want to make any changes to your living circumstances, you can avoid the prepayment penalty by just paying out the loan as promised, at least until you get past the hurdle outlined in the prepayment penalty clause of your loan agreement.
thumb_up
1 likes
I
But what if you have an adjustable-rate mortgage you’d like to trade in for a fixed-rate one before interest rates get out of control? What if the promotion to your swank new job means selling your house and moving to a different city? To do either of those things, you must pay off your original mortgage balance, potentially triggering the prepayment penalty clause.
thumb_up
34 likes
S
Any time you have to do anything that would require you to give the bank a large lump-sum payment, you should double-check to ensure a prepayment penalty isn’t involved.
When Not to Worry About a Prepayment Penalty
If you have a loan you got prior to 2014, always worry about a prepayment penalty. Literally any loan you took out before that date is subject to old (read: less consumer-friendly) rules. That said, in general, you usually (probably) don’t have to worry about a prepayment penalty if: You just make small extra principal payments here and thereYou’ve had the loan for more than a few years, as they typically expire by the fifth year at the latest The payment you want to make is less than the specified amount or percentage you can pay in a lump sum without incurring a penalty But check your contract no matter how old your loan or what you read on the internet.
thumb_up
21 likes
E
Only your contract can tell you what’s going to happen with your specific loan.
Limitations on Prepayment Penalties for Post-2014 Mortgages Anyway
In 2014, The Consumer Financial Protection Bureau finalized the rules implemented under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
thumb_up
12 likes
D
You may have heard (justifiably) negative things about its Wall Street “reform” aspect. But it did tighten consumer protections in some areas, specifically around prepayment penalties, which the bureau considers largely predatory, anyway.
thumb_up
25 likes
L
The big winners were homeowners-to-be. According to the bureau, your mortgage loan can only have a prepayment penalty if all the following are true:
It’s a Fixed-Rate Mortgage.
thumb_up
7 likes
O
If the interest rate can’t increase after you take out the loan, the bank can charge a prepayment penalty so long as it meets the other criteria.It’s a Qualified Mortgage. A qualified mortgage is one with certain less-risky features that enable the borrower to repay the loan more easily. It’s Not a Higher-Priced Mortgage. Higher-priced mortgages are those with interest rates a certain percentage higher than the average prime offer rate, a benchmark rate for mortgages.
thumb_up
50 likes
L
A jumbo loan is an example of a higher-priced mortgage. Essentially, your mortgage has to be super-duper unrisky before the lender can even add a prepayment penalty. But it doesn’t end there. In addition to limitations on what types of mortgages can even have prepayment penalty clauses, mortgage loans made after 2014 also have limits on the terms of prepayment penalties.
thumb_up
40 likes
E
Must expire after three years Capped at 2% of the unpaid balance for the first two years and 1% for the thirdNo-penalty options must be available Note that these laws apply specifically to mortgages. Your personal loan or auto loan may still have a prepayment penalty. Also note that the law prohibits several types of government-backed loans from carrying prepayment penalty clauses.
VA loans backed by the Department of Veterans AffairsFHA loans backed by the Federal Housing AdministrationUSDA loans backed by the Department of AgricultureDirect student loans backed by the Department of Education (though laws prohibit private student loans from charging prepayment penalties too) Noticeably absent from this list are Small Business Administration loans. Those could have prepayment penalties.
thumb_up
10 likes
L
However, these are just federal guidelines. Some states may have laws limiting prepayment penalties too. For example, many states outright ban them. But just because a bank does business in your state doesn’t mean your state’s laws govern their activities.
thumb_up
43 likes
S
For example, federal-chartered banks or credit unions may follow federal regulations rather than state ones. So always check.
thumb_up
49 likes
H
How to Know if Your Contract Has a Prepayment Penalty
Let’s just get it out of the way because you know it’s coming: Read your contract. Hire a lawyer to help you understand it if you have to (and can afford it).
thumb_up
19 likes
M
But you should never sign any contract you haven’t read and understand in full, word for legalese-y word, no matter how fine the print. That said, the federal and maybe some state governments have something called disclosure requirements.
thumb_up
31 likes
S
Those are legally mandated facts a lender must tell you about your loan. It’s not enough to simply put it in the contract. They have to point it out somehow.
thumb_up
40 likes
L
There are two places they usually do so. First, you may see it in the loan estimate, which you get before you even sign the paperwork.
thumb_up
12 likes
S
But there’s also supposed to be a separate document that may quite literally be labeled “disclosures.” Or it may be labeled TILA (for the Truth in Lending Act) or something similar. Whether it’s your loan estimate or the disclosure form, it must include your interest rate plus an accounting of every penny you have to pay or might have to pay in other fees. That’s the easiest way to find out if you have one. Unfortunately it’s often confusing on the loan estimate or TILA form.
thumb_up
44 likes
A
And frankly, in this case, I’m inclined to blame the form-maker: either the Federal Trade Commission or the Consumer Financial Protection Bureau, depending on the loan date and what type of loan you have. In the prepayment penalty section, example forms often say something like, “Yes, as high as $3,240 if you pay off the loan within the first 2 years.” But the blank form just makes it look like a yes or no is fine by asking simply, “Does the loan have these features?” when talking about prepayment penalties and balloon payments. Mind you, the official interpretation of the law says it’s supposed to explain at least the max penalty.
thumb_up
5 likes
W
(Look under 37(b)(4), “prepayment penalty.”) But loan officers aren’t lawyers, and the sample forms from the government make it seem like a yes-or-no question. Plus, you may need to know more than the maximum penalty. So be prepared to look for details in the long-form contract if the disclosure documents don’t have them.
thumb_up
11 likes
D
They’re usually in the promissory note or an addendum to it. And if you can’t find it, ask.
thumb_up
14 likes
S
The lender’s representative can probably point you to it pretty quickly. And you can ask them to update the loan estimate and TILA disclosure documents to include it. If it’s an established loan, the lender must also provide that information on any periodic statements it sends you, such as monthly bills, the coupon book, or interest rate adjustment notices.
thumb_up
14 likes
R
Side Note: You have the right to take possession of a contract and read it (and do whatever math you need to do to assess the terms, including a prepayment penalty) before you sign it. If a lender tries to pressure you into signing a contract without offering you enough time to read it privately or have an attorney review it, especially if they try to prevent you from leaving the premises with the contract, leave and find another lender.
How to Avoid a Prepayment Penalty
Prepayment penalties are less common now than they used to be. But pre-2014 mortgages and some vehicle and personal loans may still have them.
thumb_up
49 likes
A
And it can pay (almost literally) to avoid them — if you know how.
Wait It Out
If your loan has a prepayment penalty you don’t want to pay, you can always wait it out. The prepayment penalty clause usually expires after a few years, so it’s not that long in the grand scheme of things.
thumb_up
21 likes
W
So stay in the house, keep the car or let your kid buy it for only what you owe on the loan, or pay off a loan without a prepayment penalty instead. You can circle back to this one when the prepayment penalty clause expires.
Pay Only a Portion
Some loans with prepayment penalties still allow you to make large lump-sum payments so long as you don’t exceed a certain amount, such as 20%.
thumb_up
45 likes
M
So pay off as much as you can without triggering the prepayment penalty. That still reduces your outstanding balance and may reduce your overall loan cost over time, depending on the terms of your loan.
Just Avoid It in the First Place
The easiest way to avoid a prepayment penalty is to avoid loan contracts that have them. If you’re looking for a mortgage loan, remember that every lender that sells mortgages with prepayment penalties must have an option for a loan without a prepayment penalty it believes in good faith you will qualify for if you apply.
thumb_up
28 likes
A
If the lender doesn’t have a loan without one or you don’t qualify for it, look for a different lender. You can save yourself a lot of time and hassle by using loan search engines like Credible rather than going directly to specific banks. Unless you have a relationship with a bank, you can get just as good a deal through a search engine without negatively impacting your credit score.
thumb_up
24 likes
J
And if a lender you’ve already gotten a quote from offers a loan with a prepayment penalty, you can always ask them to ditch it. They’ll probably say no, but you can ask. They may at least have another loan product you can look into. Just remember that they add prepayment penalties for a reason, so expect the interest rate to go up.
thumb_up
11 likes
B
It might still be worth it in the case of a home loan if you know you plan to sell your house or refinance sooner than later. But you have to do the math to find out.
thumb_up
1 likes
S
If you’ve already opted for a loan that has a prepayment penalty, the only thing you can do is avoid triggering it. That means knowing what the terms of the prepayment penalty clause are.
Should You Get a Loan With a Prepayment Penalty
If you know there’s no way you’ll pay off the loan early, a prepayment penalty isn’t so bad if it means a lower interest rate.
thumb_up
30 likes
Z
But the future isn’t always so easy to predict, and you may qualify for just as good a rate without a prepayment penalty from another bank. Don’t get a loan with a prepayment penalty if:
You Plan to Refinance Soon. Banks don’t like their offers being used as a stopgap until you find a greener pasture.
thumb_up
44 likes
A
If you plan to refinance the loan within the first few years of getting it, it’s probably best to opt for a slightly higher interest rate than pay a prepayment penalty. You Plan to Sell Your Home Soon. If you plan to sell your home soon, a prepayment penalty of 2% of the unpaid balance can get pretty steep unless your penalty clause is a soft one.Early Payoff Is Important to You. If paying off debt early is important and you think you’ll have the means to do so within a few years, stay away from a prepayment penalty.
thumb_up
47 likes
E
That said, you could always get a much shorter loan term instead.
Should You Pay a Prepayment Penalty
If you’ve already signed on the dotted line and a prepayment penalty is inevitable if you pay off your loan now, paying the penalty may still be worth it in some circumstances, such as: You’d Save Money Overall. If you’d end up paying more in interest paying it off over time than you’d pay if you paid the penalty, you may as well pay the penalty. You Need to Take Out a New Loan. Your debt-to-income ratio is how much debt you have versus your income.
thumb_up
21 likes
A
It’s one of the measures lenders use to determine your creditworthiness. If you’re looking to take out a new loan, you may need to pay down existing debt to do so. If possible, pay off loans with no prepayment penalty first. You Need to Save for Retirement.
thumb_up
0 likes
I
If your monthly loan payments are making a dent in what you can save for retirement, it may be worth it to pay a prepayment penalty. The historical rate of return on investment accounts is between 7% and 10%, and the magic of compound interest can mean the difference between a miserly and comfortable retirement.You Want to Avoid Going Upside-Down.
thumb_up
29 likes
W
Whether you call it upside-down or underwater, owing more money on your home or car than it’s worth isn’t a desirable circumstance. Avoiding it may be worth it.You Need to Move — Now.
thumb_up
27 likes
J
If you have to move, it probably doesn’t make sense to keep two housing payments. You might be able to rent out your original house to cover the mortgage, but check your mortgage contract for prohibitions on that too. Under some circumstances, you may have to do the math to find out which one’s better for you.
thumb_up
42 likes
S
Sorry.
Prepayment Penalty Examples
Let’s say you took out a $200,000, 30-year fixed mortgage in January 2022 at an interest rate of 6.7%.
thumb_up
15 likes
J
It has a prepayment penalty clause that assesses 2% if you pay it off within the first year, 1% if you pay it off within the second, and 0.5% if you pay it off the third year. If you decide to pay it off early, you’re going to owe quite a lot. But how much depends on how much you still owe.
thumb_up
19 likes
G
First Year (2%). In December 2022, you still owe $198,000 (gotta love those high interest payments), and your prepayment penalty during the first year will be $3,960. Second Year (1%).
thumb_up
46 likes
B
In October 2023, you still owe $196,000. Your prepayment penalty is $1,960.Third Year (0.5%).
thumb_up
12 likes
E
In November 2024, you still owe $193,000, and your prepayment penalty is now just under $1,000. If you’re trying to save money by paying off the house early, the prepayment penalty is usually less than the interest you’d pay over the next decade or three, at least if you bought your house after 2014. But if you’re refinancing or moving, it’s possible you’d have to get a much, much lower interest rate or move into a much cheaper house for the prepayment penalty to be worth it. So doing the math is crucial.
Prepayment Penalty FAQs
Thankfully, fewer loans can have prepayment penalties these days than in years past.
thumb_up
1 likes
A
But if you have a pre-2014 mortgage or opt for a loan type that can still legally have one, it’s important to understand every aspect of how they work.
How Common Are Prepayment Penalties
In the 21st century, they’re pretty uncommon.
thumb_up
42 likes
S
But they do exist, and they may be more common if you’re still paying on an older loan.
Does Prepaying a Loan Affect Your Credit Score
It could, and not necessarily for the better. For some people, prepaying a loan lowers their debt-to-income ratio, potentially improving their odds of qualifying for a new loan.
thumb_up
22 likes
A
But it can come at a cost in the form of a temporary but very real credit score hit. First, your credit mix has a small but noticeable impact on your credit. To achieve a healthy credit mix, you want a mix of installment credit like personal loans and mortgages and revolving credit like credit cards. There are more important aspects to your credit score, but if you’re teetering on the edge of very good and excellent credit, it can make a difference in the interest rates banks offer.
thumb_up
28 likes
C
But potentially more important is the lost opportunity cost. A history of on-time payments is a much larger part of your credit score, and the faster you pay off your loan, the shorter that history becomes.
What Are the Alternatives to Prepayment
If you’ve got a windfall of cash burning a hole in your pocket but prepayment would cost you money, there are several other things you can do with it: Pay Off Higher-Interest Loans.
thumb_up
31 likes
A
If you have higher-interest loans with no prepayment penalty, pay those off first. You’ll save more money over time. It’s tempting to pay off your house ASAP if you can, and if that helps you sleep at night, go for it.
thumb_up
17 likes
C
But you might save money by paying down something else first.Hold It. Put the cash into a high-yield checking account, set it up to autopay your loan, then forget about it for a while.
thumb_up
7 likes
M
Set yourself a calendar reminder to check on it monthly to ensure your payment has come out and you aren’t out of cash, but don’t use it for anything else. Once the prepayment penalty clause expires, you can clear out the account and pay off the debt.
thumb_up
10 likes
C
You’ll earn a little extra cash on your windfall to boot.Invest It. With historical returns of around 10%, investing a larger sum of money, especially rather than paying off low-interest loans, could be a serious boost to your retirement.
Final Word
Prepayment penalties don’t have to eat up the money you thought you were saving.
thumb_up
34 likes
I
But if doing the math on your financial options seems intimidating, you can ask the loan officer at the bank for assistance doing any math you need for the loan or loans they’re providing. Otherwise, turn to a financial advisor.
thumb_up
35 likes
C
If you have a low to moderate income, the U.S. Department of Housing and Urban Development offers a network of free or low-cost housing counselors who may be able to help. Loans Borrow Money TwitterFacebookPinterestLinkedInEmail
Heather Barnett
Heather Barnett has been an editor and writer for over 20 years, with over a decade committed to the financial services industry. She joined the Money Crashers team in 2020, covering banking and credit content for banking- and credit-weary readers.
thumb_up
20 likes
S
In her off time, she enjoys baking, binge-watching crime dramas, and doting on her beloved pets.
FEATURED PROMOTION
Discover MoreRelated Articles
Loans See all Loans How to Spot & Avoid Predatory Lending (& What to Do If You're a Victim) Mortgage Home Equity Loan vs.
thumb_up
7 likes
L
Line of Credit (HELOC) - Which Is Right for You? Related topics
We answer your toughest questions
See more questions LoansHow can I pay off my car loan early
See the full answer » MortgageHow can you pay off your mortgage early
See the full answer » MortgageWhat is an adjustable-rate mortgage
See the full answer » LoansHow do I refinance a personal loan and does it make sense to do it
See the full answer »
thumb_up
15 likes
Similar Discussions
-
Hurricanes Stefan Noesen Slings power play assist CBSSports com
-
FabFitFun APK Download for Android
-
NMC ou LFP pourquoi la MG4 propose deux batteries diff rentes ? Qu est ce que a change ?
-
Cramer s week ahead Earnings season heats up and companies could keep flying barring a severe slowdown Pepsico Inc Jim Cramer
-
35 People Shamed For Sharing Their Medical Knowledge Online
-
This is who Steven Sotloff was and this is how we should remember him
-
A simple idea that could mean the end of children having to go barefoot
-
The Best Antivirus Software of 2022
-
Why I Replaced the New iMac s Keyboard Almost Immediately
-
12 Tech Wellness Gift Ideas for 2022 Healthline
-
Microalbumin test Mayo Clinic
-
How to Use Resistance Bands For Absolute Beginners Everyday Health
-
Korean Tvs
-
Jenson Button claims it would be game over for Daniel Ricciardo if he takes up Mercedes reserve driver role in 2023 F1 season
-
Would be a really good option Liverpool told to sign midfielder who is on Chelsea s radar
-
If I m suspended from Shaq s shoe Industries you best believe I m still running it Shaquille O Neal asserts suspending Sarver was not enough believes he still could run the organization covertly
-
Michael Thomas takes shot at former Jacksonville Jaguars HC Urban Meyer
-
Highest paid players in the NFL Russell Wilson s new contract sees QB become one of the league s richest players
-
Fortnite How to emote in the giant Cuddle Team Leader s head for 5 seconds
-
Mario Kart 8 Deluxe is adding 48 newly remastered classic courses as paid DLC
-
Modders are already playing Skate based on early build leak
-
Keanu Reeves doesn t want Neo from The Matrix or John Wick in Mortal Kombat
-
Assassin s Creed Valhalla creative director steps down
-
Tip 10 Strategies to Stop Binge Eating
-
Call of Duty community braces itself for spoilers as Modern Warfare is spotted in the wild
-
Alien Isolation on Switch looks better than PlayStation 4
-
Cities Skylines gets the eco themed Green Cities expansion today on Xbox One and PS4
-
Is Allure Realty From Selling Tampa a Real Brokerage? Here Are the Deets
-
Araç mtv borç sorgulama
-
Les avantages des Groupes et des Pages Entreprise LinkedIn