What Are Personal Loan Prepayment Penalties?
There’s no feeling like paying off a loan ahead of schedule. But there are times when knocking out debt before you’re required could cause more harm than good. Namely, if your lender charges a prepayment penalty.
Although personal loan prepayment penalties aren’t super common, they do exist. Learn more about this fee so you can avoid it down the line.
What are prepayment penalties and why do they exist?
Lenders make money by charging interest, something they can only do while your loan is active. That’s why you, the borrower, can save on overall interest by paying off your loan early.
The lender, on the other hand, loses profit in this scenario. As a result, it might charge a prepayment penalty on personal loans to dissuade borrowers from paying ahead. Prepayment penalties also help lenders replace some of the interest it would have collected while your loan was still active.
Many types of loans can have a prepayment penalty. However, prepayment penalties are more common on conventional mortgages and auto loans.
Most major personal loan lenders (including all of our picks for the best personal loans) allow you to pay loans off early at no extra charge.
How do personal loan prepayment penalties work?
Prepayment penalties usually come in three forms:
- Flat fee: A lender could have a flat fee as a prepayment penalty. For instance, it might charge you an extra $500 if you pay off your loan before the end of your term, regardless of your loan balance.
- Percentage-based fee: Your personal loan prepayment penalty could be a percentage of your loan balance. Let’s say that your lender charges a percentage-based prepayment penalty fee of 5%. You also have $5,000 left on your loan. In that case, your prepayment penalty would be $250 (because 5% of $5,000 is $250).
- Interest-based fee: This style of prepayment penalty is based on how much interest you’d pay over a certain period of time. Some lenders, for example, might charge a year or two’s worth of interest as a prepayment penalty.
Prepayment penalties are sometimes weighted heavier at the start of your loan and gradually decrease over time.
If you only have a few months left on your loan and you pay it off, will the lender lose that much interest? Probably not. That’s why it may reduce its prepayment penalty the closer you are to the end of your loan term.
How do you know if your personal loan has a prepayment penalty?
Before you agree to a loan, it’s vital that you research the lender and its products.
You can usually find a lender’s fee schedule on its website. If it’s hard to find, take note — lack of transparency is a red flag. FAQs are also a good place to find information about fees.
If you have a personal loan but aren’t sure if it has a prepayment penalty, check your promissory note. This is the contract you signed during closing. If you find a clause indicating a prepayment penalty, you’re out of luck — it’s probably there to stay.
You could also call your lender and ask for a loan pay-off statement. There you should see if your personal loan has a prepayment penalty.
Is it worth paying off a personal loan with a prepayment penalty?
You’ll have to do some simple math to figure out if the cost of a prepayment penalty is worth it.
Imagine that you just took out a personal loan for $25,000 with a 16.00% annual percentage rate (APR) for a five-year term. Using a personal loan calculator, you can see that you’d pay around $11,477 in total interest if you stuck to your repayment terms.
Because interest rates are high, you plan on paying off your loan in three years, with the last payment as a lump sum. This would help you save a little more than $2,000 in interest.
But you just noticed that your loan has a 5% prepayment penalty. You’ll have about $11,500 left on your loan when you pay it off. That means you’ll be charged a prepayment penalty of $575.
In this example, it’s worth paying off the loan early. The $575 prepayment penalty is much cheaper than $2,000 of interest.
Paying off a personal loan and your credit score
Sometimes, paying off debt can have a negative impact on your FICO score, albeit temporarily. If you’re planning a major money move (like buying a car), then you may want to wait until you’ve completed that transaction before paying off your loan early.
Paying off your loan (whether early or on time) could impact the following credit factors:
- Length of credit history: The length of your credit history makes up 15% of your FICO score. If your personal loan is one of your oldest accounts, don’t be surprised if your credit score drops when you pay it off.
- Credit mix: Credit mix makes up 10% of your score. This measures the variety in the types of debt you juggle, such as credit cards and installment loans. If your personal loan is your only loan, then your credit mix will be less varied once that loan is paid off.
- Debt-to-income ratio: Debt-to-income (DTI) ratio isn’t a part of your FICO score, but it’s something that most lenders consider. Your DTI ratio represents how much money you earn versus how much you owe. It might get a boost when you pay off your loan (since you’ll have one fewer monthly payment on your plate).
How can you avoid personal loan prepayment penalties?
It shouldn’t be too difficult to avoid personal loan prepayment penalties. Still, here are two things that could help you avoid this annoying (and potentially expensive) fee.
- Improve your credit score: Generally, the worse your credit, the more fees on your loan. Check your credit score for free with LendingTree Spring. If your score is below 670, you might want to improve your credit score before applying.
- Compare lenders: Just because some lenders charge a prepayment penalty doesn’t mean they all do. Prequalify for a handful of loans by using LendingTree’s loan marketplace. Checking rates (and fees) won’t impact your credit score.
What other fees can apply to personal loans?
Unless you’re with a lender with no required fees (like LightStream and SoFi), you could owe any (or all) or the fees below.
Origination fee
An origination fee is an upfront fee. Upfront doesn’t usually mean out-of-pocket, though. Instead, the lender will typically deduct the fee from your loan proceeds before sending them to you.
Some lenders don’t charge origination fees. Those that do could apply one to every loan. Others might only charge an origination fee if you have fair or bad credit.
Late payment fee
You might get a fee for missing payments. Some late fees are a flat dollar amount. Others are a percentage of the late payment.
Many lenders extend a grace period for late payments. You might only be responsible for a late fee if you are five, 10 or 15 days past your due date. For specifics, check your loan documents or ask your lender directly.
Check payment fee
Some personal loan lenders charge a fee every time you pay by check. Presumably, the lender uses this for payment processing.
Returned payment fee
If you make a payment by check (either manually or through autopay) and that check bounces, your lender may charge a fee.
Paper copy fee
You might have to pay extra if you want a paper copy of your loan documents.
Application fee
Of all the fees on this list, application fees are probably the least common — and can be a sign of predatory lending. If a lender wants to charge you to apply for a personal loan, refuse and check with competitors.