- 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. 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. 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. 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.
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. 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. There are several models lenders use to determine prepayment penalties.
- A set amount of money, such as $3,500
- A set number of months’ interest, such as six months’ interest
- A percentage of the outstanding principal, such as 2% of the remaining loan balance
- A 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. 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. 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.
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.
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 there
- You’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. 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. 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.
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. 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. 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.
- Must expire after three years
- Capped at 2% of the unpaid balance for the first two years and 1% for the third
- No-penalty options must be available
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 Affairs
- FHA loans backed by the Federal Housing Administration
- USDA loans backed by the Department of Agriculture
- Direct 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.
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. For example, federal-chartered banks or credit unions may follow federal regulations rather than state ones. So always check.
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). 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. 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.
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. 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. 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. (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. They’re usually in the promissory note or an addendum to it.
And if you can’t find it, ask. 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.
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. 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.
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%. 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.
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.
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. 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.
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. 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. 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. 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. 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. 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. 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. 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. 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%. 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.
- 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%). In November 2023, you still owe $196,000. Your prepayment penalty is $1,960.
- Third Year (0.5%). 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. 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. 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. 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.
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. 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. 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. 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. 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.
Prepayment penalties don’t have to eat up the money you thought you were saving. 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. 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.