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Introduction
A prepayment penalty, also known as an early payoff penalty, is a fee you will have to pay if you pay back your loan ahead of the predetermined schedule. If the terms of your loan include a prepayment penalty clause, then you will be penalized if you pay off your debt early. Typically, a penalty fee is a percentage of your loan’s total remaining balance. It can also be expressed as a lump sum flat-rate penalty or what is known as a “reducing penalty”—where the penalty depends on how much of you’ve already paid off. The more you’ve paid off, the smaller your fee.
Loans That Could Have Prepayment Penalties
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Mortgages
If you do see a prepayment penalty, it’s most likely on a mortgage loan. Some mortgage loans still come with these fees, which can add up to thousands of rupees. Not all mortgages have them, but if yours does, you likely agreed to it in your closing documents.
Typically, you won’t be charged a prepayment penalty when you put small chunks of extra money towards your loan principal. But if you pay off a large part of your balance at once, or pay off the entire balance within the first few years (even if it’s due to selling or refinancing your home), you may owe the lender a prepayment penalty.
The actual cost of a prepayment penalty varies from lender to lender. The fees can either be calculated as a percentage of the principal balance remaining on your mortgage, or as a lump sum. Some states also have laws that place additional time and financial limits on these fees.
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Other Loans
Prepayment penalties are less common on other types of loans, but it’s possible you’ll encounter them at some point. For instance, certain auto loans come with a prepayment penalty clause.
Some personal loans do as well, though many personal loan lenders specifically advertise that they don’t have these fees. You might also come across a prepayment penalty on a home equity line of credit or HELOC.
Types of Prepayment Penalties
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Soft Prepayment Penalty - A soft prepayment penalty allows a borrower to sell his home at any time without penalty, but if he chooses to refinance the mortgage, then it will be subject to the prepayment penalty.
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Hard Prepayment Penalty - A hard prepayment penalty, on the other hand, sticks the borrowers with a penalty if they sell their home OR refinance their mortgage. This is the tougher of the two and basically gives a borrower no option of jumping ship if they need to sell their home quickly after obtaining a mortgage.
How Much Do Prepayment Penalties Cost?
The prepayment penalty fee is often 80% of six months of interest. Here are a few points to note:
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It can vary by lender
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But it might be 80% of six months interest
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Meaning six months of interest-only mortgage payments
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Multiplied by 80%, which can be very expensive depending on the loan amount and interest rate
Does Prepayment Make Sense?
Prepayment penalties were devised to protect lenders and investors that rely on years and years of lucrative interest payments to make money. When mortgage loans are paid off quickly, regardless of whether by refinance or a home sale, less money than originally anticipated will be made. It’s a simple concept. Here are a few important points to note:
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Prepayment penalties protect the lender/investor who purchases the loan, from early prepayment associated with a refinance or home sale since they won’t make as much money on the loan
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Assuming it isn’t kept until maturity, or worse, paid off almost immediately, the interest rate might be lower for the borrower
How to Deal with Prepayment Penalties on An Existing Loan
If you have a mortgage, check your closing documents, monthly billing statements, your loan coupon book and in any interest rate adjustments. If you’re not able to track down this information, check the same with your lender.
If a prepayment penalty is part of your contract, you can’t make it go away. But you can find out what actions will trigger the penalty and do your best to avoid them. Talk to your lender and find out the exact details of the prepayment penalty. You can also run some basic numbers to find out what you’ll owe if you pay off the loan early or refinance it — and whether that move will save or cost you money in the long run.
FAQs
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Can I repay my loan ahead of schedule? Is prepayment of loan allowed?
Yes, most banks allow you to repay the loan ahead of schedule by making lump-sum payments. However, many banks charge early repayment penalties up to 2-3% of the principal amount outstanding. Prepayment penalty may vary according to the reasons and source of funds. Most banks do not charge a prepayment penalty if you deposit more than your EMI payable on a periodic basis.
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What should be your strategy in dealing with the prepayment penalties?
Give yourself a comfortable time. Do not hurry your purchase or loan in any case. Shopping around for a home loan will help you to get the best financing deal. Comparing, seeking clarification and negotiating with banks may save you thousands of rupees in prepayment penalties,
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Do personal loans and line of credit require a good credit score?
Yes. If you are looking to avail competitive interest rates then a good credit score can help in availing loans and line of credit at better interest rates and other loan terms.
End Note
A lot of loan borrowers are not aware of what a “prepayment penalty” is, much to their own detriment even months or years after signing mortgage loan documents. This is especially true because it is often poorly explained, or not brought up altogether. It is important on the part of the credit provider to clarify such penalties and also the borrower to clarify doubts.