Understanding Prepayment Penalties on Personal Loans: The Ultimate Guide

Q: What are prepayment penalties on personal loans?

Prepayment penalties are fees some lenders charge if you pay off part or all of your loan early. Lenders can use different calculations to set the prepayment penalty amount. It may be a fixed rate or a percentage of your outstanding balance on the loan, for instance. Not all lenders charge prepayment penalties.

Q: Is it illegal for a private lender to charge a prepayment penalty for a personal loan?

No. Prepayment penalties are legal for personal loans. However, not all personal loans impose these fees. Prepayment penalties are illegal for student loans and VA, FHA, and USDA home loans.

Q: How can you avoid a prepayment penalty on a personal loan?

Shop around for loans without prepayment penalties. These penalties should be listed on loan estimates and closing documents; read through these materials carefully before signing off on the loan. Ask your lender whether there is a prepayment penalty if you’re not sure.

Understanding Prepayment Penalties on Personal Loans: The Ultimate Guide

Jason SteeleUpdated January 17, 2023

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

If you’ve taken out a personal loan and you’re considering paying it off early, check first to see if there is a prepayment penalty on the personal loan. Paying your loan in full before it’s due can save you hundreds of dollars in interest. However, you may have to pay a fee if your loan has a prepayment penalty.Read on to learn more about prepayment penalties, how to know if your loan has them, and how to avoid these fees.

What Is a Prepayment Penalty on a Personal Loan?

A prepayment penalty on a personal loan is a fee that some lenders charge if you pay part or all of your loan earlier than the full term, or length, of the loan agreement. For instance, with long-term personal loans, a borrower might want to repay their loan ahead of schedule. If the loan has a prepayment penalty, they would have to pay this fee. Prepayment penalties can be found on different types of loans, including some mortgages and auto loans, as well as personal loans.

Is Charging a Prepayment Penalty on a Personal Loan Legal?

While prepayment penalties are legal on some types of loans, including personal loans, they are not allowed on other loans. Because of federal legislation implemented in 2014, many mortgages no longer have prepayment penalties. For instance, VA, FHA, and USDA home loans are not allowed to have prepayment penalties. Some mortgages do still have them, though, so check your loan documents if you’re not sure. And if you are thinking about paying off your student loans early, you’ll be happy to know that these loans do not have prepayment penalties. However, personal loans and business loans are allowed to impose prepayment penalties. Not all of them do. It depends on the lender.

Who Determines the Prepayment Penalty on a Personal Loan?

Just as each lender sets the requirements for the personal loan, they also determine the prepayment penalty on a personal loan, as well as the fee that will be charged. What’s the reason for prepayment penalties? When a borrower makes prepayment on a personal loan, the lender doesn’t earn as much money from interest on the loan. This is an important factor in how a personal loan operates and why lenders charge prepayment penalties. If you are thinking about paying a personal loan early, it’s important to note that some lenders charge a prepayment penalty to try to deter you from doing so. If you do pay off your loan in advance, you will have to pay the fee, which helps them make up for the interest they are losing out on.

How Is a Prepayment Penalty on a Personal Loan Calculated?

Prepayment penalties can be calculated in different ways. Some lenders charge a certain percentage of the loan balance. Others may charge you a specific amount of interest. And still others may simply charge a fixed fee.

How Much Is the Prepayment Penalty on a Personal Loan?

The prepayment penalty on a personal loan varies by lender and how they calculate the penalty. For instance, they might charge you a flat fee or 1% to 2% of your remaining loan balance. Or they may charge you a certain amount of interest, such as 12 months’ worth. Read your loan contract to see how the prepayment penalty is determined, and then do the math to see how much it will cost you. If you’re almost finished paying off your loan, it may be cheaper to continue making your regular payments rather than paying it off earlier.

How Do You Know if There Is a Prepayment Penalty on Your Personal Loan?

There are pros and cons to personal loans, and a prepayment penalty may be a drawback that comes with some loans. As mentioned, not all personal loans have prepayment penalties. Check your loan agreement to see whether it has this penalty or not. If the original terms of your loan don’t include a prepayment penalty, the lender is not allowed to charge you one later. Avoiding a Prepayment Penalty on a Personal LoanAs you’re shopping around and comparing different personal loans, you can look for options that don’t include a prepayment penalty. Prepayment penalties must be listed on the disclosures and documents that are part of your loan agreement. If you have any doubts whether a prepayment penalty applies to a loan, ask the lender. Before accepting a loan with a prepayment penalty, make sure you fully understand all the terms and conditions regarding the fee, including how much it is, and whether it applies to partial payments, full payments, or both.Unfortunately, once you accept a loan with prepayment penalties, you can’t avoid this fee if you decide to prepay your loan.

The Takeaway

A prepayment penalty is a fee many borrowers don’t consider — and may not be aware of — when they take out a personal loan. While not all personal loans charge a prepayment fee, some do. It’s best to avoid this fee if you can. When you apply for a personal loan, read the fine print, ask the lender to explain the loan details fully, including whether there is a prepayment fee, and make sure you know all the terms and conditions before accepting it. If you are looking for a personal loan, Lantern can help you find one with the best rates and terms for you. Lantern lets you compare many types of personal loans, including loans without prepayment penalties.

Frequently Asked Questions

What are prepayment penalties on personal loans?

Is it illegal for a private lender to charge a prepayment penalty for a personal loan?

How can you avoid a prepayment penalty on a personal loan?

Photo credit: iStock/Charday Penn

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About the Author

Jason Steele

Jason Steele has been writing about credit cards and award travel since 2008. One of the nation's leading experts in this field, he has contributed to dozens of personal finance and travel outlets and has been widely quoted in the mainstream media.

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