What's The Deal With Prepayment Penalties?

If you were giving basic life advice to a child, one of the first things you would tell them is, "Don't be late." Show up late to your job and you'll be in trouble. Show up late to class and you'll be marked tardy. Show up late to a movie and you'll… miss some commercials and maybe, one preview. (Okay, bad example.) The fact remains that being on time is important. The only thing considered better than being on time is being early.

There are plenty of aphorisms to back this up. You might have heard “the early bird gets the worm,” or “early to bed and early to rise makes a man healthy, wealthy, and wise.” Whether getting to the airport, choir practice, or a job interview, the advice is always the same: be early. Some people even subscribe to the maxim that, "if you're not early, you're late." All in all, there are very few situations where being early is a bad thing.

Surprisingly, one of those situations can be paying off a loan. All kinds of different loans, from personal loans to auto loans to mortgages, may have prepayment penalties.  The specific language might differ, but the word “prepayment” is usually in there.

Here's an example: you take out an installment loan with a repayment period of three years. Two years into that repayment period, you discover you can afford to pay off the remaining balance immediately. At first, it may seem like a responsible thing to do, right? Usually, yes, but with a prepayment penalty, you would be charged an additional fee for paying off the remaining balance. After all, the agreement was that you pay off the loan in three years, not two.

These penalties might seem counterintuitive, but the reasoning behind them is simple: early repayment means less money for the lender. Most loans assess Interest and fees annually, so if you pay off a three-year loan in two years, that lender doesn't get to collect the interest and fees on the third year of the repayment period.

Fortunately, avoiding prepayment penalties is also fairly simple as they will always be disclosed in the fine print of the loan contract. You probably hear this a lot, but always read the fine print of a contract before you sign it. If you're worried about overlooking them,  don't hesitate to ask your loan officer about prepayment penalties. Asking questions and doing thorough research before taking out a loan is the best way to ensure that you are getting the best terms possible. Read more about installment loans in this blog post.