Look at you, so responsible. You received a financial windfall â stimulus check, tax refund, work bonus, inheritance, whatever â and youâre using it to pay off one of your debts years ahead of schedule.
Good for you! Exceptâ¦ make sure you donât get charged a prepayment penalty.
Now wait just a minute, you say. Iâm paying the money back early â early! â and my lender thanks me by charging me a fee?
Well, in some cases, yes.
A prepayment penalty is a fee lenders use to recoup the money theyâll lose when youâre no longer paying interest on the loan. That interest is how they make their money.
But you can avoid the trap â or at least a big payout if youâve already signed the loan contract. Weâll explain.
What Is a Loan Prepayment Penalty?
A prepayment penalty is a fee lenders charge if you pay off all or part of your loan early.
Typically, a prepayment penalty only applies if you pay off the entire balance â for example, because you sold your car or are refinancing your mortgage â within a specific timeframe (usually within three years of when you accepted the loan).
In some cases, a prepayment penalty could apply if you pay off a large amount of your loan all at once.
Prepayment penalties do not normally apply if you pay extra principal in small chunks at a time, but itâs always a good idea to double check with the lender and your loan agreement.
What Loans Have Prepayment Penalties?
Most loans do not include a prepayment penalty. They are typically applied to larger loans, like mortgages and sometimes auto loans â although personal loans can also include this sneaky fee.
Credit unions and banks are your best options for avoiding loans that include prepayment penalties, according to Charles Gallagher, a consumer law attorney in St. Petersburg, Florida.
Unfortunately, if you have bad credit and canât get a loan from traditional lenders, private loan alternatives are the most likely to include the prepayment penalty.
If your loan includes a prepayment penalty, the contract should state the time period when it may be imposed, the maximum penalty and the lenderâs contact information.
âThe more opportunistic and less fair lenders would be the ones who would probably be assessing [prepayment penalties] as part of their loan terms,â he said, âI wouldnât say loan sharkingâ¦ but you have to search down the list for a less preferable lender.â
Prepayment Penalties for Mortgages
Although youâll find prepayment penalties in auto and personal loans, a more common place to find them is in home loans. Why? Because a lender who agrees to a 30-year mortgage term is banking on earning years worth of interest to make money off the amount itâs loaning you.
That prepayment penalty can apply if you want to pay off your loan early, sell your house or even refinance, depending on the terms of your mortgage.
However, if there is a prepayment penalty in the contract for a more recent mortgage, there are rules about how long it can be in effect and how much you can owe.
The Consumer Financial Protection Bureau ruled that for mortgages made after Jan. 10, 2014, the maximum prepayment penalty a lender can charge is 2% of the loan balance. And prepayment penalties are only allowed in mortgages if all of the following are true:
- The loan has a fixed interest rate.
- The loan is considered a âqualified mortgageâ (meaning it canât have features like negative amortization or interest-only payments).
- The loanâs annual percentage rate canât be higher than the Average Prime Offer Rate (also known as a higher-priced mortgage).
So suppose you bought a house last year and then wanted to sell your home. If your mortgage meets all of the above criteria and has a prepayment penalty clause in the mortgage contract, you could end up paying a penalty of 2% on the remaining balanceÂ â for a loan you still owe $200,000 on, that comes out to an extra $4,000.
Prepayment penalties apply for only the first few years of a mortgage â the CFPBâs rule allows for a maximum of three years. But again, check your mortgage agreement for your exact terms.
The prepayment penalty wonât apply to FHA, VA or USDA loans but can apply to conventional mortgages â although the penalty is much less common than it was before the CFPBâs ruling.
âItâs more of private loans â loans for people whoâve maybe had some struggles and canât qualify for a Fannie or Freddie loan,â Gallagher said. âThat block of lending is the one going to be most hit by this.â
How to Find Out If a Loan Will Have a Prepayment Penalty
The best way to avoid a prepayment penalty is to read your contract â or better yet, have a professional (like an attorney or CPA) who understands the terminology, review it.
âYou should read the entirety of the loan, as painful as that sounds, because lenders may try to hide it,â Gallagher said. âGenerally, it would be under repayment terms or the language that deals with the payoff of the loan or selling your house.â
Gallagher rattled off a list of alternative terms a lender could use in the contract, including:
- Sale before a certain timeframe.
- Refinance before a term.
- Prepayment prior to maturity.
âThey avoid using the word âpenalty,â obviously, because that would give a reader of the note, mortgage or the loan some alarm,â he said.
If youâre negotiating the terms â as say, with an auto loan â donât let a salesperson try to pressure you into signing a contract without agreeing to a simple interest contract with no prepayment penalty. Better yet, start by applying for a pre-approved auto loan so you can get a pro to review any contracts before you sign.
Do you have less-than-sterling credit? Watch out for pre-computed loans, in which interest is front-loaded, ensuring the lender collects more in interest no matter how quickly you pay off the loan.
If your lender presents you with a contract that includes a prepayment penalty, request a loan that does not include a prepayment penalty. The new contract may have other terms that make that loan less advantageous (like a higher interest rate), but youâll at least be able to compare your options.
How Can You Find Out if Your Current Loan Has a Prepayment Penalty?
If a loan has a prepayment penalty, the servicer must include information about the penalty on either your monthly statement or in your loan coupon book (the slips of paper you send with your payment every month).
You can also ask your lender about the terms regarding your penalty by calling the number on your monthly billing statement or read the documents you signed when you closed the loan â look for the same terms mentioned above.
What to Do if Youâre Stuck in a Loan With Prepayment Penalty
If you do discover that your loan includes a prepayment penalty, you still have some options.
First, check your contract.
If youâll incur a fee for paying off your loan early within the first few years, consider holding onto the money until the penalty period expires.
If you donât have a loan with a prepayment penalty, contact your lender before sending additional money to ensure your payment is going toward principal â not interest or fees.
Additionally, although you may get socked with a penalty for paying off the loan balance early, itâs likely you can still make extra payments toward the balance. Review your contract or ask your lender what amount will trigger the penalty, Gallagher said.
If youâre paying off multiple types of debt, consider paying off the accounts that do not trigger prepayment penalties â credit cards and federal student loans donât charge prepayment penalties.
By using techniques like the debt avalanche, debt snowball and debt lasso methods, you can tackle your other debts while giving yourself time to let a prepayment penalty period expire.
Tiffany Wendeln Connors is a staff writer/editor at The Penny Hoarder. Read her bio and other work here, then catch her on Twitter @TiffanyWendeln.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.