Personal Loan Prepayment Penalties and Other Common Mistakes
Paying off a loan early may sound like a positive achievement — but if you aren’t aware of the fine print on your loan agreement, early repayment can end up costing you more. Personal loan prepayment penalties are a way for lenders to recover money lost on interest when a loan is repaid early; they may be good for their bottom line, but not yours.
Here’s what you need to know about having a prepayment penalty on a personal loan, how to avoid them and other common mistakes people make with personal loans.
What is a prepayment penalty for a personal loan?
While paying off a personal loan early is typically a momentous accomplishment, some lenders may charge what’s known as a prepayment penalty. This is a fine some lenders charge when a borrower chooses to pay off a personal loan early.
Not all loans come with a prepayment penalty; they are mostly applied when paying a business loan off early or paying an auto loan off early. However, it never hurts to contact your lender and ask whether you’ll be charged a fee for paying off your loan early.
The Consumer Financial Protection Bureau (CFPB) recommends that borrowers read the fine print before agreeing to a loan with a prepayment penalty. Any such penalty will be disclosed in the loan document, so it’s important to read your loan agreement carefully and understand the terms.
Why do lenders charge a prepayment penalty?
Lenders typically make a majority of their money on the interest they charge to your loan. When a borrower repays their loan ahead of schedule, the lender makes less money on the loan.
Some lenders may charge a prepayment penalty to make up for the loss in funds from interest should you repay your debt early. Prepayment penalties can also serve as a hindrance to borrowers looking to pay their personal loan off early so the lender can collect on the entire amount of interest on the loan.
How much does a prepayment penalty cost?
The cost of a prepayment penalty will depend on the lender. A lender typically charges a prepayment penalty in the form of:
- A single, fixed fee
- A certain percentage of your loan
- The cost of interest on the remaining loan term
If your lender charges a prepayment penalty on your personal loan, you’ll want to understand the total cost in order to decide whether you’d like to pay off the loan early. You can learn more about how much a loan may cost you overall by using LendingTree’s personal loan calculator.
How do you know if your personal loan has a prepayment penalty?
Most lenders are upfront about whether they charge prepayment penalties. However, some may require a bit of digging to find out more about whether they charge a prepayment penalty and how much it is. If you find it difficult to find information about a lender’s prepayment penalty, contact them directly to find out more about their personal loan requirements and fees before agreeing to a personal loan with that lender. You should also be sure to read the fine print about a loan’s prepayment penalty before signing.
How can you avoid a prepayment penalty on a personal loan?
While you could attempt to negotiate with the lender to remove the prepayment penalty from your loan, many personal loan lenders do not charge this fee, so it may be best to simply choose a different company.
If you’d like to repay your loan early, be sure to crunch the numbers. If you’re almost done paying off the balance of your loan, it may be cheaper to continue making monthly payments and avoid the fee. However, you might find that the cost of the prepayment penalty is less than the amount you’d pay in interest over the life of the loan, so it could be worth it to repay the loan early.
If you’re in need of a personal loan and you’d like to avoid a prepayment penalty, shop around and compare offers from various lenders. You can do this with LendingTree, which provides transparency regarding lenders’ rates, terms, fees and loan amounts.
What are other common mistakes to avoid when taking out a personal loan?
1. Not examining your credit first
When applying for a personal loan, your credit health and financial information will heavily influence whether you qualify and the loan terms you’ll receive. Checking your credit can help you suss out which lenders may consider your loan before you ever apply for prequalification.
Once you have your credit reports in hand, give them a close examination. You’ll want to identify and dispute errors, such as out-of-date debt information.
2. Not getting prequalified
With prequalification, you’ll submit a preliminary application with a lender in order to see whether you’re likely to be eligible and, if so, for what kinds of terms. The prequalification process allows you to more thoroughly compare lenders, though not all lenders offer prequalification.
Most lenders perform a soft credit check during the prequalification process, which won’t impact your credit. When you visit a lender’s website, you’ll likely get the option to “check rates.” When submitting an application for prequalification, you’ll provide simple information, like your income and housing situation, plus how much you want to borrow and for what purpose.
You can also use a loan marketplace like LendingTree to potentially receive multiple loan offers with one application. If you prequalify with one or more lenders, you’ll get to see the kinds of terms you may be able to get.
But while prequalification is a great method to compare lenders, it’s no guarantee that you’ll get a personal loan when formally applying.
3. Not comparing options from more than one lender
Personal loans are just that: personal. Each lender offers different loan terms and has their own method of evaluating your credit profile. Settling for the first loan you find means you could miss out on another lender’s lower interest rates, more flexible loan terms or better customer service.
If you have good to excellent credit, APRs on personal loans may start as low as 10.73% — meanwhile, borrowers with fair or bad credit may see APRs of 65.93% or higher, according to a March 2021 LendingTree study on personal loans.
A strong job history and low debt-to-income ratio may help you qualify for a more affordable personal loan. To find competitive personal loan terms for your financial situation, check prequalification offers from at least three lenders.
Compare factors such as:
- Available loan amounts
- Range of repayment terms
- Interest rates
- Fees, such as an origination fee
Ideally, you’ll find a lender that minimizes your cost of borrowing.
4. Not paying attention to the APR
When you’re shopping for a personal loan, you’re probably laser-focused on the monthly payment to be sure you can afford it. But don’t stop there — the APR (annual percentage rate) is a more accurate measure of your loan cost. It includes the interest rate plus other loan fees, such as origination fees. If there are no fees, the APR equals the interest rate.
Once you have an estimated APR or range of APRs from prequalification offers, you can use a personal loan calculator to see the potential costs you can expect on a personal loan over its repayment period.
5. Not reviewing potential fees
Personal loans may come with extra costs, from origination fees to prepayment penalties and late fees. Not all lenders charge fees, but if you don’t check for them, you could end up with a surprise down the road. Before signing for the loan, ask about any fees involved and when the lender charges them.
- Origination fees are a common personal loan fee, and can typically range from 1% to 8% of the loan amount. It is either deducted from your loan proceeds or added to the principal balance. For example, a 4% origination fee on a $10,000 loan would cost you $400.
- Prepayment penalties are charged when you pay off the loan before the repayment period is up. The amount of the penalty and the conditions that trigger the fee can vary by loan and lender.
- Late fees are charged when a payment is overdue, either as a dollar amount or percentage of the overdue payment. The lender may also report a late payment to the credit bureaus after 30 days, which can impact your credit scores.
6. Not taking the loan term into account
The loan term (also known as the repayment period) is the number of months over which you’ll repay the personal loan. Personal loans with a shorter term usually have higher monthly payments, but lower overall interest charges. A longer term means lower monthly payments, but a higher overall cost to borrow.
Understanding how your term impacts the total cost of borrowing can help you choose the best loan for your needs.
7. Not reading the contract
Too often, people sign things they haven’t read. Make sure you take the time to read the fine details when taking on debt. If you encounter a lender with a costly personal loan product, reviewing their fee structure and conditions can reveal hidden fees. For example, if you aren’t aware that your lender charges a prepayment penalty, you can end up saddled with costly fees if you plan to get out of debt sooner.
Your lender should disclose all the terms of the loan. If you have questions or uncertainties, ask questions. Further, it’s important to double-check for any mistakes on your loan application. Honest mistakes may be understandable, but they can affect your loan eligibility and terms.
8. Using your personal loan for something frivolous
A low-cost personal loan to pay for a vacation or luxury purchase could be more affordable than charging the expense to a credit card, but that doesn’t make it the best decision for your money. Taking on the liability of a loan to cover a nonessential expense could come back to haunt you, especially if you find you’re unable to keep up with the payments.
Good uses for personal loans include consolidating debt or covering emergency expenses. Debt consolidation may allow you to repay your debt for less, and emergency expenses are necessary but can be so costly that you can’t pay them out of pocket.
9. Applying for too much credit at once
Don’t buy a house, boat, car or other major purchase on credit right before applying for a personal loan or while you’re in the process of getting the loan. Taking out additional credit before or during your personal loan inquiry may hurt your chances of qualification. In addition, taking out a personal loan while you’re in the process of closing on a mortgage isn’t a good idea either.
Make sure you’re only applying for one loan at a time, and give it some time before you attempt another inquiry on your credit for another purpose.
After you receive the loan funds, keep an eye on your spending. If you’ve consolidated debt under one loan but keep adding to your credit card balance, you may be pushed further underwater. Juggling two types of debt can make it harder to pay off the loan.
10. Not considering a cosigner
Not everyone needs a cosigner, and there are many pros and cons for both you and the person cosigning a personal loan. On the plus side, a cosigner can help you qualify for the loan and get a more desirable interest rate. However, the cosigner bears a lot of burden here; they’ll be responsible for payments if you can’t make them, and missed and late payments will affect both your and your cosigner’s credit.
Consider these benefits and drawbacks before asking someone to cosign a loan. If your credit is poor, it may be a good idea to have a cosigner ready on the sidelines.
11. Making late payments
While making on-time payments can improve your credit, late payments adversely affect your credit scores. Depending on the loan terms, you also might have to pay a late fee if the payment is overdue, which increases your overall cost of borrowing. The late fee may be charged as a dollar amount or a percentage of your unpaid monthly payment, though the exact amount will vary by lender. Some lenders don’t charge late fees at all.
To avoid late payments, set up a calendar alert a few days before the payment is due. The lender may also let you sign up for automatic payments to be withdrawn from your checking account. (Some lenders will even provide a discount on your APR for doing so.)
12. Not repaying the loan
You may be wondering: What happens if I don’t pay back a personal loan? The truth is, nothing good.
When you become late on payments, the lender may report the delinquent debt to the credit bureaus. This will cause a negative mark on your credit. If you continue to miss payments for 90 days or more, you may default. By this point, you’ll likely be receiving calls for payment. Not long after, you can expect the lender to send the loan to a collection agency.
If the loan falls within the statute of limitations, the lender may also go to court and request a judgment to garnish your wages, place a lien against your property or withdraw the funds from your bank account.
13. Not considering alternative options
Don’t make the mistake of thinking a personal loan is the best option out there. For example, if you have good credit, you could seek out a credit card with a promotional APR offer.
Credit card issuers commonly offer cards with a promotional 0% APR to draw in new customers. These offers typically last 12 to 21 months and can be a great way to consolidate debt or make a major purchase for less, so long as the balance is repaid before the offer ends. (If you don’t, you could be hit with deferred interest from the purchase date.)
If you have fair or bad credit, you’re liable to see lower loan costs with a secured loan. They can be easier to qualify for too, as there’s less risk for the lender. Secured loans are backed by collateral, meaning if you fail to repay the debt, the lender can seize the asset.