Personal Finance Advice

You would think that lenders love when borrowers pay off loans early.  The truth is that lenders prefer for borrowers to keep paying right along with the amortization schedule and not deviate from the terms of the loan.  Why? The reason is simple: If you pay off the loan early, you don’t have to pay the full amount of interest you were supposed to pay.  Lenders want to get the full amount of interest out of you, and if you pay the loan off quicker than you were supposed to then the lender loses out on profit.

Needless to say, some lenders don’t like this scenario at all.

Some lenders are so adamant that they are going to get all the money out of you as possible that they put prepayment penalties as a term of the loan.  This means that if you pay off the loan faster than you were supposed to you’ll owe additional money to the lender.  Sometimes the prepayment penalty is relatively small while other times it’s a substantial enough amount to make you want to not pay the loan off early at all.

The tricky thing about prepayment penalties is that most borrowers don’t even know that their loans feature them.  Unless you have heard of prepayment penalties before, most people would think it’s an absurd idea to make someone pay extra for paying off a loan early.  Not knowing about a prepayment penalty, however, does not protect a borrower from having to pay one.

The only way to know for sure whether or not a loan has a prepayment penalty is to read the loan documents, preferably before signing them.  Even if a loan representative tells you that there is no prepayment penalty - but then you sign documents agreeing to pay a prepayment penalty if you pay the loan off early - then you’re going to have to pay.

Which loans usually feature this fee? Mortgages and car loans can both feature prepayment penalties, but other types of loans can feature this fee as well.  Although it is less common to encounter this fee with loans designed for people with excellent credit, prepayment penalties have been known to creep into the loan documentation of even the most creditworthy borrowers.

Always ask whether a loan has a prepayment penalty, and regardless of what the representative claims you should still read the complete document all the way through before signing.  If you go to pay off a loan early and find out that there is a fee involved then you should look at the math behind the transaction and figure out if it would be better to go ahead and pay if off (and pay the penalty) or if you should stick the money somewhere else because the fee is simply too substantial.