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, like, one preview. (Okay, bad example.) But the fact remains that being on time is very, very important. And the only thing that's 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 it's getting to the airport or to choir practice or to a job interview, the advice is always the same: be early. Some hardcore believers 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 an out-and-out 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, have what is called a prepayment penalty. (Sometimes the specific language will 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 that you can afford to pay off the remaining balance right then and there. This seems like the smart, responsible thing to do, right? (Right!) But with a prepayment penalty you would get charged an additional fee for paying off that 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. Interest and fees are assessed annually for most loans, so if you pay off a three-year loan in two years, that lender doesn't get to collect the interest and fees on that third year of the repayment period.

Luckily, 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, go ahead and just ask your loan officer if there is a penalty for paying early. Asking questions and doing all your research before taking out a loan is the best way to insure that you're getting the best terms possible. Read more about installment loans in this blog post.