A prepayment penalty is a fee that lenders charge a borrower if they pay off their entire loan early. This fee allows the lender to recoup some of the interest they would have made if the borrower had the loan for the entire term.
What Is A Prepayment Penalty?
Lenders charge a prepayment penalty to borrowers who pay for a loan’s outstanding balance before its due date. These penalties can be applied to the remaining principal (or a part of it), or they could be a fixed charge applied to any prepayment made.
Lenders have the freedom to decide if they will charge a prepayment penalty, and some lenders apply these penalties only to certain types of loans, while others waive them as part of their strategy to attract borrowers through more flexible and favorable conditions.
What is the Purpose of a Prepayment Penalty?
Lenders must allocate their capital on profitable mortgages and loans, and to do so, they screen borrowers to assess their creditworthiness and payment capacity.
This costly effort involves resources, including time, money, and technology. Once a lender has approved a loan, an early prepayment could reduce the lender’s earnings since the funds will be returned without further interest. This risk is also known as prepayment risk.
As a result, lenders may want to compensate themselves for the effort they made to analyze the borrower’s creditworthiness, and this is often the reasoning behind imposing a prepayment penalty.
Types of Prepayment Penalties
Depending on the moment when they are applied, or how the fee is calculated, a prepayment penalty can be classified as follows:
- Time-bound prepayment penalty: Lenders sometimes only apply prepayment penalties during the early stages of a loan’s lifetime, such as within the first three years of the loan. Once these three years have passed, the prepayment penalty may be lowered or waived entirely.
- Fixed-charge prepayment penalty: In some cases, prepayment penalties can be a fixed charge regardless of the size of the prepayment or when it occurred. In practice, this means that a lender could charge a $200 prepayment penalty when a borrower prepays for a portion or the entire balance of a loan.
- Percentage-based prepayment penalty: The most common way to calculate prepayment penalties is to apply a certain percentage to the amount paid. In these cases, lenders establish the percentage to be charged at each stage of the loan, and the penalty can be easily estimated by multiplying this percentage by the prepayment amount.
Why Do Borrowers Prepay their Loans?
Loans can be prepaid for a wide variety of reasons, including:
- The borrower no longer needs the money: In some cases, a borrower may have already fulfilled the financial need they initially had and have recouped the capital involved. In that scenario, they may decide that there’s no need to continue paying interest on the debt, and, therefore, they can fully prepay the loan’s balance.
- For debt-consolidation purposes: Debt consolidation is when a person or business consolidates various credit accounts into one, usually at a lower APR. When this happens, the borrower prepays all the outstanding balances of the old accounts as part of the consolidation process.
- A cheaper source of capital has been found: If a borrower secures a loan that offers a lower interest rate, and has enough money to cover the balance transfer, a prepayment will be made towards the old account.
- The loan’s underlying asset has been sold: A car loan or a mortgage has an underlying asset that backs the loan—also known as collateral. If a borrower successfully sells this collateral, they may use the funds to prepay the loan’s balance to avoid further interest charges.
The Cost of Prepayment Penalties
Since prepayment penalties are part of each lender’s policies, they can vary significantly from one lender to another.
Prepayment penalties can be fixed or variable, depending on the lender and the type of loan. Prepayment penalties tend to be a percentage of the total cost of the loan. These penalties must be paid upfront and are deducted from the borrower’s bank account once the prepayment is made.
Lenders may also make an exception if the prepayment is justified. For example, if a borrower has sold a home, the lender may waive the prepayment penalty of the mortgage associated with the property. In most cases, this will depend on how many years have passed since the loan was taken and the size of the prepayment involved.
Prepayment Penalties and the Dodd-Frank Act
The Dodd-Frank Act was introduced in 2010 as part of an effort to bring transparency and stability to the U.S. financial markets. It’s meant to regulate certain aspects of the country’s banking, investment, and financial activities.
One of its purposes is to regulate some practices associated with mortgages to avoid predatory behavior. These regulations are described in the bill’s Title XIV “Mortgage Reform and Anti-Predatory Lending Act,” and they include certain provisions regarding prepayment penalties, such as:
- Residential mortgage loans that are considered “qualified mortgages” must not be charged with a prepayment penalty.
- Lenders must offer consumers the option of picking between a residential mortgage loan that charges a prepayment penalty fee and one that doesn’t.
- In most cases, prepayment penalty fees cannot be financed.
These and other provisions limit important aspects of prepayment penalties and how and when they can be applied to mortgages offered to consumers in the United States.
How do Prepayment Penalties Affect Credit Scores?
A prepayment penalty doesn’t directly affect a person’s credit score, but the prepayment does. For example, the partial prepayment of a credit account could reduce the person’s credit utilization rate, which could impact their credit score.
On the other hand, the full prepayment of a credit account will move its status to “closed,” which could also affect the average age of the person’s credit accounts, a variable that’s important in the calculation of their credit scores.
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