Prepayment Penalty

Prepayment penalty summary:

• A prepayment penalty is a fee some lenders charge customers if they pay their loan off early.

• Lenders use prepayment penalties to recoup some of the interest they would have earned if the loan had been paid for the entire term.

• Prepayment penalties are more common with certain types of loans, like mortgages.

Prepayment penalty definition and meaning

When you borrow money, the lender expects to earn a specific amount back through interest and (sometimes) fees. If you decide to pay a loan off earlier than expected, the lender loses out on the interest you'd have paid. Charging a prepayment penalty is one way lenders recoup interest payments they miss out on if you pay a loan off early. 

Depending on the terms of your loan agreement, the prepayment penalty could be a fixed amount, or it could be a percentage of the remaining loan balance.

Key concept: A prepayment penalty is a fee that a lender charges you for paying a loan off ahead of schedule.

More about prepayment penalty

Prepayment penalties are typically associated with larger loans, like mortgages. Lenders charge prepayment fees so they don’t lose out on interest when a mortgage is paid off early. According to the Consumer Financial Protection Bureau (CFPB), a prepayment penalty typically applies if you pay off the mortgage within a particular number of years (usually three or five years).

The prepayment penalty could apply even if the reason you paid off the loan was because you sold the home. On some loans, a prepayment penalty could kick in if you pay off a large amount of your mortgage at one time. 

Prepayment penalty: a comprehensive breakdown

There are two types of prepayment penalties:

• Soft: A soft prepayment penalty applies when you refinance the mortgage during the loan's early years. A soft prepayment penalty doesn't penalize you for selling the home during that time. 

• Hard: A hard prepayment penalty applies to any action that causes your mortgage (or a significant portion) to be paid off. This includes refinancing, paying off a large portion of your mortgage, or selling your home. 

How much a prepayment penalty will cost you depends on the lender. Here are four common ways lenders calculate prepayment penalties:

• Percentage of the remaining balance. A lender may assign a percentage, such as 2% of the outstanding principal, as the penalty. 

• Fixed amount. Charging a fixed amount isn't typical, but it does happen. A lender may set a flat fee for paying a loan off within the early years of the loan term. 

• Specific number of months' interest. A lender may charge a specified number of months in interest when a loan is paid off early. 

• Sliding scale. If a mortgage is paid off during the first year, the penalty may be 2%. If paid off a year later, the penalty may drop to 1% of the outstanding principal balance. 

When you apply for a loan, consider the possibility that you might want to pay it off ahead of schedule. Find out before your loan is final whether you’d have to pay a fee for doing so by checking your loan agreement. 

Achieve doesn’t charge prepayment penalty fees.