The reason that lenders dislike early repayments (known as ``prepayments'' or ``voluntary prepayments'') is that most lenders match their assets-- the loans they've made to others-- with liabilities of their own. This can lead to lenders facing significant interest rate risk.
The core problem with prepayment risk is that it can stack the deck against investors. Callable bonds favor the issuer because they tend to make interest rate risk one-sided. When interest rates rise, issuers benefit from locking in low rates.
The early payoff may disturb their cash flows and reduce overall interest receipts. Additionally, these fines make borrowers stay with the same lending terms, discouraging refinancing or switching lenders too often.
Paying off a loan may lower your credit score, but if you practice good credit habits the effect will be minimal.
Paying off the loan early can put you in a situation where you must pay a prepayment penalty, potentially undoing any money you'd save on interest, and it can also impact your credit history.
Key Takeaways
A prepayment penalty clause states that a penalty will be assessed if the borrower significantly pays down or pays off the mortgage, usually within the first five years of the loan. Prepayment penalties serve as protection for lenders against losing interest income.
Most states allow lenders to impose a fee if borrowers pay off mortgages before a specific date – typically in the first three years after taking out a mortgage. While Alaska, Virginia, Iowa, Maryland, New Mexico, and Vermont have banned prepayment penalties, other states allow them with certain conditions.
Lenders expect to receive interest income from the monthly payments on any given loan, and when the loan is paid off early, the income is less than expected. To make up for this loss, lenders often require the borrower to pay a fee, a premium, or more colloquially referred to as a “penalty”.
A prepayment penalty is a fee that some lenders charge when borrowers pay off all or part of a loan before the term of the loan agreement ends. Prepayment penalties discourage the borrower from paying off a loan ahead of schedule (which would otherwise cause the lender to earn less in interest income).
1. Reduction in overall interest cost: By prepaying a Personal Loan, you can reduce the overall interest cost of the loan, as the unpaid interest component decreases. 2. Shorter loan tenure: Prepayment can reduce the loan tenure as it will bring down the outstanding principal amount.
Understanding Prepayment Risk
As such, prepayment risk is the risk that the borrower repays the outstanding principal amount (or a portion of the outstanding principal amount) prematurely and, in turn, causes the lender to receive less in interest payments.
Let's say you borrowed $25,000 for five years at 5% interest. If you pay on time for the full 60 months, you'll pay $3,307 in interest. Paying it off early can eliminate some of that interest assuming you are paying simple interest, which most loans are.
The interest rate differential (IRD) is one type of prepayment charge you may be required to pay to your lender when you pay all or part of the mortgage before the term ends. For most fixed-rate closed mortgages, the prepayment charge is usually 3 months' interest or the IRD, whichever is greater.
Prepayment penalties are usually only due within the first few years of the loan, so if you can, try to wait to sell, refinance, or pay off the loan until that time.
Prepayment penalties can be charged in a variety of ways. They may be calculated as a percentage of the remaining loan amount — typically 1 to 2 percent. The penalty could be equal to a certain number of months' interest. Or some lenders may charge a flat fee.
Unlike mortgages issued by some traditional lenders, Federal Housing Administration (FHA) loans do not have prepayment penalties.
Keep in mind that borrowers can try to negotiate with their lender to remove a prepayment penalty clause – or search for a lender that doesn't charge this fee. You also can ask your lender to quote you a comparable loan without a prepayment penalty so you can compare your options.
No, your credit score will not reduce if you prepay your loan. Infact, your credit score won't change much if you prepay your loan unless you close the loan on time.
Whether you can be charged a penalty for paying off your mortgage early depends on what type of mortgage you have and the specific terms of your mortgage loan. Some loans have pre-payment penalties during the first years of the loan.
If you pay $200 extra a month towards principal, you can cut your loan term by more than 8 years and reduce the interest paid by more than $44,000. Another way to pay down your mortgage in less time is to make half-monthly payments every 2 weeks, instead of 1 full monthly payment.
It suggests that homeowners who can afford substantial extra payments can pay off a 30-year mortgage in 15 years by making a weekly extra payment, equal to 10% of their monthly mortgage payment, toward the principal.
Sometimes, it makes sense. For people who bought a house with private mortgage insurance, prepaying can cut back on the time it takes to reach the loan-to-value ratio you need to save what can be hundreds of dollars a month.