Prepayment Penalty

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Prepayment Penalty?

In many of the mortgage contracts made between the parties, many times there is a prepayment clause that states that if payment is made in advance by the borrower before the due date of payment, then it shall treat that the terms and conditions of the contract are not adhered to by the borrower. Hence, would be liable to pay the penalty known as the prepayment penalty.

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Sometimes borrowers, shift to a different loan or a different lender to avoid this fees entirely if the lender is not ready to negotiate the penalty. It is always advisable to get quotes from different lenders to understand different schemes and access to their prepayment penalty calculator to ensure full understanding before entering into a loan agreement.

Key Takeaways

  • A prepayment penalty is a fee or charge imposed by a lender on a borrower for paying off a loan or mortgage before the scheduled due date. It serves as a financial penalty to discourage early repayment and compensates the lender for potential loss of interest income.
  • Prepayment penalties can be categorized as hard or soft prepayment penalties. 
  • The specific terms of the penalty, such as a flat amount, a percentage of the loan balance, or the cost of interest, are determined by the lender and outlined in the contract. 

Prepayment Penalty Explained

Prepayment penalty is levied when one party of the contract pays the other party sum of any debt before its due date, it is known as prepaymentPrepaymentPrepayment refers to paying off an expense or debt obligation before the due date. Often, companies make advance payments for expenses as well as goods and services to shed their financial burden. Advance payments also act as a tool to attain monetary benefits. Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.read more. Now, if the borrower makes the prepayment of the loan, then it would be liable to pay the penalty for the same as mentioned in the contract created by the parties at the beginning of the deal.

This penalty on the prepayment of the loan acts as a tool for discouraging the prepayment as such prepayment leads to loss of the lender’s business of the funds. By charging such penalties, the lender would compensate for his business loss.

There is prepayment riskPrepayment RiskPrepayment Risks refers to the risk of losing all the interest payments due on a mortgage loan or fixed income security due to early repayment of principal by the Borrower. This Risk is most relevant in Mortgage Borrowing which is normally obtained for longer periods of 15-30 years.read more in the mortgage contracts wherein the borrower pays an amount in advance from its due date. Then, the lender might lose his business. So, it is generally specified in the mortgage contract mentioning the details about the prepayment penalty calculation in case of the prepayment. The terms and conditions of the clause are to be mentioned by the lender well in advance when completing the deal of such a loan.

If payment is made in advance by the borrower before the due date of repayment, it would be liable to pay the prepayment penalty. The amount of the penalty that is applicable will be calculated as per the terms and conditions of the contract made between the parties. By charging the penalties, the lender will get compensation for his business.

Generally, there are two types of prepayment penalties: hard prepayment penalties levied if the borrower makes payment in advance from either sale of the home or the refinancing, and soft prepayment penalties set if the borrower makes payment in advance from the refinancing.

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Types

Let us understand types of prepayment penalty mortgages and other types of loans through the discussion below.

Prepayment Penalty types

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Examples

Let us understand the concept of a prepayment penalty mortgage and other related loans with the help of a couple of examples.

Example #1

Mr. Tom took the home loan ten years back from the bank named ABC Bank Ltd. for 20 years. The current outstanding balance of the loan is $1,000,000. When making the contract, they decided that he would pay 3% of the balance amount as the prepayment penalty if the borrower completes the loan prepayment. So, if the borrower wants to repay the loan, what will be his penalty?

In this case, it is levied based on the percentage of the loan balance, which is 3%, as mentioned in the contract.

Prepayment Penalty Amount = Balance Amount of Loan * Percentage of Penalty
Prepayment Penalty Example
  • = $1,000,000 * 3% 
  • = $30,000

Example #2

More than one million customers of the British gas company had their gas bills reduced after the company removed the pre-payment penalty in April 2023.

After the removal, the pre-paying customers would pay just as much as any customer who pay on delivery. As a result, each bill would be cut down by a whopping 59 pounds. This would help around 4.5 million householding in the UK to have their gas bills reduced.

Overall, if the average savings for each household is £15, the overall savings would be over £10 million in the next three months of this policy being incorporated.

How is it Calculated?

Depending on the terms of agreement between the two parties, the calculation might differ from contract to contract. However, the use of a prepayment penalty calculator needs to be understood to fully understand this concept. Let us do so through the points below.

  • A Flat Amount of Penalty: Under this, a flat amount is mentioned in the contract, which the borrower must pay in case of the early payment of dues.
  • Based on Percentage of Balance of Loan: The loan prepayment penalty is sometimes calculated based on the loan’s remaining balance percentage.
  • Cost of Interest: This can be levied based on a certain amount of the month’s interest per the contract condition.

Why Do They Exist?

It is a common confusion on why are borrowers being charged a penalty for paying in advance in an economic state where loans are being faltered upon more than ever. Let us understand the situation from a wider perspective and why is there a prepayment penalty mortgage and other such loans through the explanation below.

When the borrower makes the payment before the due date of the payment of the loan amount, then there are chances that the lender of the money might lose its business. That is so because the lender, in case of the prepayment, will lose the interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more, which otherwise he will get if the borrower makes the repayment on the due date.

So, to protect the lender’s interest and provide compensation against such loss, a prepayment penalty clause is entered in the contract between the lender and borrower where it will be levied on the borrower if he makes the payment in advance from the date when it becomes due. It usually varies from lender to lender as per the terms and conditions of the contract.

How Much Does It Cost?

Prepayment penalty costs are based on the terms and conditions mentioned in the contract executed by the lender and borrower at the beginning of the contract. It can be calculated based on the percentage of the balance of a loan or based on a certain number of the month’s interest, or it can be a flat amount.

How to Avoid Prepayment Penalties in Mortgage?

If the borrower wants to avoid the prepayment penalties, one should look for a lender who does not charge the penalty in case of the loan prepayment; however, if the contract is already executed with the penalty clause. The borrower should look at the terms and conditions and check if it can save the penalty by making partial payments because some lenders do not charge prepayment penalties in case of partial repayment.
Also, one can avoid the prepayment penalties by selling the asset in case of the soft prepayment penalties instead of refinancing the same.

Frequently Asked Questions (FAQs)

1. What is a prepayment penalty vs. an early termination fee? 

A prepayment penalty is a fee a lender charges if a borrower pays off a loan before the agreed-upon term. It is typically based on a percentage of the remaining loan balance. On the other hand, an early termination fee is a charge imposed by a service provider or contract for ending a service or agreement before its intended completion. 

2. What is a prepayment penalty vs. yield maintenance? 

A prepayment penalty is a fee a lender charges when a borrower pays off a loan before the specified term. The penalty amount is usually based on a predetermined formula or percentage of the remaining loan balance. On the other hand, yield maintenance is a method used in commercial real estate loans to compensate the lender for the loss of expected interest income due to early loan repayment. 

3. Do prepayment penalties affect credit scores? 

Prepayment penalties themselves do not directly impact credit scores. However, if a borrower struggles to make the required prepayment penalty payment and defaults on their loan, it could negatively affect their credit score. 

This article is a guide to the what is Prepayment Penalty. Here, we explain its examples, how to calculate, costs, and how to avoid paying this penalty. You can learn more about accounting from the following articles: –

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