Look at you so responsible. You've received a financial slump – stimulus check, tax refund, work bonus, inheritance, etc. – and you're using it to pay off one of your debts years ahead of schedule.
Good for you! Except … make sure you are not charged a prepayment penalty.
Now just wait a minute you say I'll pay the money back early – early! – and my lender thanks me by charging me a fee?
In some cases, yes.
A prepayment penalty is a fee that lenders use to get back the money they lose if you stop paying interest on the loan. With this interest they earn their money.
However, you can bypass the trap – or at least get a large payout if you've already signed the loan agreement. We'll explain.
What is a credit prepayment penalty?
A prepayment penalty is a fee that lenders charge when you prepay all or part of your loan.
Typically, a prepayment penalty only applies if you pay off the entire balance – for example because you sold your car or refinance your mortgage – within a certain period of time (usually within three years of accepting the loan).
In some cases, there may be a prepayment penalty if you repay a large portion of your loan in one go.
There are usually no prepayment penalties for paying an additional principal amount in small chunks at a time. However, it is always a good idea to check with the lender and your loan agreement.
Which loans have prepayment penalties?
Most loans do not include any prepayment penalty. They're usually used for larger loans like mortgages, and sometimes auto loans too – although personal loans can come with this sneaky fee too.
According to Charles Gallagher, a consumer law attorney in St. Petersburg, Florida, credit unions and banks are the best ways to avoid borrowing with prepayment penalties.
Unfortunately, if you have bad credit and cannot get credit from traditional lenders, then the most likely possibility that private credit alternatives include the prepayment penalty.
If your loan includes a prepayment penalty, the contract should include the length of time it might be imposed, the maximum penalty, and the lender's contact information.
"The more opportunistic and less fair lenders would be the ones who would likely evaluate (prepayment penalties) as part of their loan terms," he said. "I wouldn't say loan shark … but you have to look down the list for a less preferred lender."
Mortgage prepayment penalties
Although auto and personal loans come with prepayment penalties, home loans are more common. Why? Because a lender who agrees to a 30 year mortgage term is betting on earning years of interest in order to make money on the amount they lend you.
This prepayment penalty can apply when planning to prepay your loan, sell your home, or even refinance, depending on the terms of your mortgage.
However, if the contract includes a prepayment penalty on a newer mortgage, there are rules about how long it can be valid and how much you can owe.
The Consumer Financial Protection Bureau ruled that for mortgages taken out after January 10, 2014, the maximum prepayment penalty a lender can charge is 2% of the loan balance. And prepayment penalties are only allowed on mortgages if all of the following conditions are met:
The loan has a fixed interest rate.
The loan is considered a “qualifying mortgage” (that is, it cannot have characteristics such as negative amortization or interest payments).
The annual percentage of the loan cannot be higher than the average Prime Offer Rate (also known as a higher-priced mortgage).
For example, suppose you bought a home last year and then wanted to sell your home. If your mortgage meets all of the above criteria, and there is a prepayment penalty clause in the mortgage contract, you may end up paying a 2% penalty on the remaining balance – an additional one for a loan that you owe $ 200,000 on Fine of $ 4,000.
Prepayment penalties only apply to the first few years of a mortgage – the CFPB rule allows for a maximum of three years. However, double-check your mortgage agreement for your exact terms.
The prepayment penalty does not apply to FHA, VA or USDA loans, but can apply to conventional mortgages – although the penalty is far less common than it was before the CFPB's decision.
"It's more of a private loan – loans for people who may have had problems and cannot qualify for a Fannie or Freddie loan," Gallagher said. "This block of credit will be hit the hardest."
This is how you can find out if a loan has an prepayment penalty
The best way to avoid a prepayment penalty is to read your contract – or better yet, have a professional (like a lawyer or CPA) who understands the terminology checked.
"You should read the entire loan, painful as it sounds, because lenders may be trying to hide it," Gallagher said. "Generally this is done under repayment terms or in the language in which the loan is repaid or your home is sold."
Gallagher rattled off a list of alternative terms a lender could use in the contract, including:
- Selling before a certain period.
- Refinancing before a term.
- Prepayment before the due date.
"You obviously avoid using the word 'penalty' as it would alert the reader of the note, mortgage or credit," he said.
When negotiating the terms – with a car loan, for example – don't let a seller pressure you to sign a contract without agreeing to a simple interest rate agreement with no prepayment penalty. Better still, apply for a pre-approved car loan first so you can ask a professional to review all contracts before you sign.
Do you have less than sterling credit? Look out for prepaid loans that have interest priority and make sure the lender collects more interest no matter how quickly you pay back 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 the loan less advantageous (such as a higher interest rate), but at least you can compare your options.
How can you find out if your current loan has a prepayment penalty?
If a loan is subject to a prepayment penalty, the servicer must provide information about the penalty either on your monthly statement or on your credit voucher booklet (the slip you send monthly with your payment).
You can also ask your lender about the terms of your penalty by calling the number on your monthly statement or reading the documents you signed when you took out the loan. Pay attention to the above conditions.
What to do if stuck on a prepayment penalty loan?
If you find that your loan has a prepayment penalty, you still have a few options.
First, check your contract.
If there is an early repayment fee on your loan in the early years, you should keep the money until the penalty expires.
If you don't have a loan with a prepayment penalty, check with your lender before sending any additional money to make sure your payment is toward principal – not interest or fees.
Even though you may face an early repayment penalty, it is likely that you will still be able to make additional payments for the balance. Review your contract or ask your lender what amount will trigger the fine, Gallagher said.
If you are paying off multiple types of debts, you should pay off the accounts that do not incur any prepayment penalties. Federal credit cards and student loans do not impose prepayment penalties.
Techniques like the debt avalanche, debt snowball, and debt lasso methods can help you tackle your other debts while also giving yourself time to let an prepayment penalty expire.
Tiffany Wendeln Connors is an associate and editor at The Penny Hoarder. Read her bio and other work here, then catch her on Twitter @TiffanyWendeln.
Ready to stop worrying about money?
Get the Penny Hoarder Daily