What Is a Personal Loan Prepayment Penalty?
Taking out a personal loan can make sense if you want to consolidate debt or you have a big ticket expense to pay for. And paying off the loan early might seem like a good plan if you’re hoping to minimize interest charges.
What you may not know, however, is that some lenders can tack on a prepayment penalty if you decide to pay your loan off ahead of schedule. If you have a personal loan or you’re planning on getting one soon, it’s helpful to understand what a prepayment penalty means and how it can affect the cost of borrowing.
What Is a Personal Loan Prepayment Penalty?
Personal loans and other loans, such as a mortgage or car loan, can include a prepayment penalty in the loan agreement. This penalty is essentially a fee your lender can charge you for paying your loan off early. This is usually noted in a specific prepayment clause that outlines when the fee applies and how much it is.
But why do personal loan lenders charge a prepayment penalty to begin with? The answer is fairly simple.
When a lender makes a personal loan to you, you agree to pay it back with interest according to a set repayment schedule. The lender makes money off the interest charges you pay. When you repay a personal loan early, the lender loses out on some of the interest you would have otherwise paid if you’d stuck to the original loan schedule. A prepayment penalty allows lenders to recoup some of that lost interest.
How Much Are Personal Loan Prepayment Penalties?
Personal loan lenders can decide for themselves when to charge a prepayment penalty and how much to charge. And there are different ways this fee can be calculated.
For example, personal loan prepayment penalties may be based on:
- Lost interest. Some personal loan lenders can charge prepayment penalties equivalent to a certain number of months’ worth of interest payments.
- A set dollar amount. Other lenders may choose to keep things simple with prepayment penalty calculations and charge a flat dollar amount. The upside of that is that you’ll always know what the fee is, regardless of when you decide to pay your loan off.
- Loan balance. Still other lenders may calculate personal loan prepayment penalties as a percentage of what you still owe on the loan.
Keep in mind that some lenders may shift these amounts over time, reducing the prepayment penalty the closer you get to the end of the loan term. In some cases, the fee may disappear entirely once enough time has passed. Again, all of this should be spelled out in the loan agreement so you know what you may have to pay before you commit to the loan.
Should You Pay a Personal Loan Prepayment Penalty?
Whether it makes good financial sense to pay a prepayment penalty for a personal loan depends on what your goals are and how quickly you want to be rid of the debt. Making a final decision typically involves doing some simple math to compare what you may pay for the fee against what you could pay in interest charges if you continue paying the loan as scheduled.
For example, say you take out a $20,000 personal loan at 9% with a five-year repayment term. Your total interest charges for the loan would come to $4,910. If you paid the loan off in four years instead, however, you’d pay $3,890 in interest, a difference of $1,020. You could then compare that to the prepayment penalty to see how they stack up.
If the amount you’d pay for the prepayment penalty would be less than what you’d pay in interest, then paying the loan off early and accepting the fee might be worth it. On the other hand, if the prepayment penalty would cost you more money than it would save you, you’d likely be better off paying the loan as scheduled.
How to Avoid Personal Loan Prepayment Penalties
Before you sign off any personal loan, review the loan terms so you know what you might pay for a prepayment penalty and when that fee could be triggered.
The simplest way to sidestep paying this fee is to choose a personal loan with no prepayment penalty. This typically means doing a little research and comparison shopping on your part to find personal loan lenders that don’t charge prepayment penalties.
If you’re unable to find a personal loan option without a prepayment penalty, then the next best way to avoid paying it is to simply pay your loan as scheduled. Remember that you could still save money by comparing personal loans from different lenders to find the one with the lowest APR and fees. The better your credit score and financial profile, the better your chances of landing a low interest rate.
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Rebecca Lake is a freelance writer specializing in personal finance,
credit and debt. She’s a contributor to U.S. News and World Report,
Forbes Advisor and The Balance and her work has appeared online at CreditCards.com,
Money-Rates.com and dozens of other top publications.