What Is a Prepayment Penalty?

Quick Answers

Penalty period

Usually 1 to 3 years

Typical penalty

2-5% of payoff amount

QM loans

No prepay penalty

Check your note

Before paying early

A prepayment penalty is a fee some lenders charge if you pay off your loan -- or make large extra payments -- before a specified period ends.

Lenders make money on the interest you pay over the life of a loan. When you pay off a loan early -- through refinancing, selling the property, or making extra payments -- the lender loses the future interest it expected to collect. A prepayment penalty compensates the lender for this lost revenue.

Prepayment penalties are most common in certain personal loans, some auto loans, and historically in some mortgage products. They're now prohibited on most qualified residential mortgages (with some exceptions for higher-priced loans). Always check your loan agreement for prepayment language before signing.

Key Facts About Prepayment Penalties

Hard prepayment penalty: Applies if you refinance or sell during the penalty period -- the most restrictive type.
Soft prepayment penalty: Only applies if you refinance, not if you sell the property.
Typical penalty: Often 25% of the outstanding loan balance, or equal to 6 months of interest.
Penalty period: Usually the first 15 years of the loan. Once past this window, you can prepay freely.
Qualified mortgages: Under Dodd-Frank, most qualified mortgages cannot have prepayment penalties after 3 years, and penalties are capped in years 13.

How to Calculate a Prepayment Penalty

% of Balance: Penalty = Outstanding Balance x Penalty Rate

Example: $180,000 x 2% = $3,600 penalty

6-Month Interest: Penalty = (Balance x Annual Rate / 12) x 6

Example: ($180,000 x 6% / 12) x 6 = $5,400 penalty

Common Prepayment Penalty Mistakes

Assuming every loan today is penalty-free: Most qualified residential mortgages are, but some non-QM loans, investment-property mortgages, and a number of personal and auto loans still carry them. Don't assume -- check the note on your specific loan.
Confusing a prepayment penalty with other closing or rate-lock fees: Origination fees, discount points, and rate-lock fees are charged when you take out the loan regardless of what you do later. A prepayment penalty only triggers if and when you pay the loan off early -- they're separate costs with separate purposes.

Frequently Asked Questions

Does my mortgage have a prepayment penalty?+

Check your loan documents -- specifically the note and the Truth in Lending Act (TILA) disclosure. If you're unsure, call your lender and ask. Most conventional and government-backed mortgages (FHA, VA, USDA) today do not have prepayment penalties.

Can I avoid a prepayment penalty?+

Yes -- negotiate to have it removed before signing, choose a loan without one, or wait until the penalty period expires before refinancing or paying off the loan. Some loans allow a certain amount of extra principal payments per year without triggering the penalty.

Is a prepayment penalty worth it if I get a lower rate?+

Sometimes. If the lower rate saves you significantly more than the penalty costs, it may still make sense. Use a refinance calculator to compare the break-even point after factoring in the penalty.

Do personal loans have prepayment penalties?+

Some do -- it's common with certain personal lenders. Always read the loan agreement before accepting. Many online lenders and credit unions offer personal loans with no prepayment penalty.

Does making extra mortgage payments trigger a prepayment penalty?+

It depends on your loan terms. Hard penalties apply to any extra principal payments above a certain amount. Soft penalties only apply to full payoffs through refinancing. Read your specific loan documents to understand the trigger.