A prepayment penalty is a fee that lenders charge borrowers who pay off all or part of their loans ahead of schedule. These fees are outlined in loan documents and are allowed in certain types of loans, like conventional mortgages, investment property loans and personal loans. Fees typically start out around 2% of the outstanding principal balance and fall to zero over the first several years of a loan.

Prepayment penalties can be unwelcome obstacles for people trying to reduce their debt or build equity in their property. If you want to avoid these penalties, you can often do so by avoiding certain types of loans, paying off your loan after the fees phase out or by negotiating directly with your lender before closing on a loan.

What Is a Prepayment Penalty?

A prepayment penalty, or “prepay,” is a fee that borrowers are charged if they pay off a loan within several years after taking out a loan. Lenders typically stop charging them after the loan has been in repayment for three to five years. Lenders charge these fees in order to dissuade borrowers from paying off or refinancing their mortgages, which would cause the lender to lose out on interest income.

Federal law prohibits prepayment penalties for many types of home loans, including FHA and USDA loans, as well as student loans. In other cases, the early payoff penalties that lenders can charge are permitted but include both time and financial restrictions under federal law.

How a Prepayment Penalty Works

Not many people can afford to pay off a loan just a year or two after taking it out. But a lot of people refinance their loans to take advantage of a lower interest rate or if their credit improves. Prepayment penalties can make it more expensive to refinance within the first several years after taking out a loan.

Prepayment penalties vary by lender and loan type. Some lenders don’t charge them; in other cases, they’re restricted. When prepays are charged, they’re only charged during the first few years of a loan, after which they phase out—usually within three to five years.

Prepayment penalties are only charged on certain types of loans, but they’re always laid out in detail in loan documents—which is why it’s important to read disclosures before taking a loan offer.

Prepayment Penalty Costs

Prepayment penalties typically start out at around 2% of the outstanding balance if you repay your loan during the first year. Some loans have higher penalties, but many loan types are limited to 2% as a maximum. Penalties then decline for each subsequent year of a loan until they reach zero.

When prepayment penalties are assessed, it’s usually on the outstanding balance at the time the loan is paid back early.

Many prepayment clauses also include provisions for borrowers to pay off up to a certain percentage of their mortgage (20% is typical) without encountering a fee. So, if you want to make extra payments in the early years of your loan without refinancing or paying it off completely, prepayment penalties may not be an issue.

Sample Prepayment Penalty Schedule

Year of Loan Prepayment Penalty (as a percent of outstanding loan balance)
1
2%
2
1.5%
3
1%
4
0.5%
5
—

Some lenders calculate prepayment penalties differently. For example, some lenders charge fees equal to a certain number of months of interest, rather than the outstanding loan balance. But, regardless of how these fees are structured, they must always be listed in a loan agreement in order to be enforceable.

Prepayment Penalty Example

Let’s say there’s a new homeowner, Susan, who just bought her first house. To afford her purchase, she took out a 30-year mortgage for $400,000 at 4% that includes a prepayment clause. The clause calls for early payment fees on a sliding scale over the first five years of her loan.

Now, two years after taking her loan, Susan’s credit score has improved, interest rates have fallen and she wants to take advantage and refinance the $385,000 remaining on her loan. She finds another mortgage lender who will refinance her new loan for 15 years at 3.25%. All told, refinancing will save her $325 per month, but first, she’ll have to pay a prepayment penalty of $5,775 (or 1.5% of her outstanding loan balance) when she pays off her current loan.

In this scenario, Susan would recoup her penalty in a little over two years (once closing costs are added in) through savings from her new loan. If she plans to keep her house for at least three or four years, then refinancing and paying the penalty may make sense. If she thinks she may move in the next year or two, then she may just want to stick with her original loan.

How to Avoid a Prepayment Penalty

If you want to avoid prepayment penalties on your next mortgage loan, there are certain lenders to avoid. These include alternative lenders (these are typically online, non-bank lenders), lenders that specialize in subprime loans and those that promise fast funding.

There are also loan products that you should stay away from in order to avoid getting hit with these fees. For example, it’s best to stay away from alternative loan products and instead stick to loans that you can get anywhere. That way, you’ll be in a better position to negotiate away prepayment penalties if your lender tries to include them.

Another thing you can do to avoid prepayment penalties is to avoid frequent refinancing, as it signals to your lender that you’re more likely to refi as soon as rates fall. You could also try to find a co-signer or offer a higher down payment in exchange for a better loan term (including the elimination of a prepayment fee).

Lastly, if you want to avoid prepayment penalties, you could just wait until prepayment penalties have phased out before paying off or refinancing your loan. Or, you can make allowable extra payments that are under the limit for how much of your mortgage you can pay back each year without triggering early payoff fees.

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Types Of Loans That May Include A Prepayment Penalty Clause

Prepayment penalties are prohibited for certain types of loans, including USDA and FHA loans. In other cases, the amount that lenders can charge in prepayment penalties is limited—prepayment penalties can’t start higher than 2% for conventional mortgages, for example.

But, in other cases, prepayment penalties are extremely common provisions of loan agreements, though they may still be negotiable.

Types of loans where a borrower should be on the lookout for prepayment fees include:

Is Paying a Loan Prepayment Penalty Worth the Cost?

If you can afford to completely pay off a mortgage within the first year or two after borrowing—or refinance at a much lower rate—then it may be beneficial to just pay the penalty, as the amount of money that you save in interest payments may greatly outweigh the cost of the penalty.

However, if you can’t pay off the mortgage until prepayment penalties are almost completely phased out anyway, then it may be better just to wait. The interest that you continue to pay on your loan will be tax-deductible anyway, and the prepay will only be deductible if it’s a business expense. The one exception may be that if you can refinance your loan at a much lower rate and save so much in interest that you’ll recoup the cost of your prepayment penalty within just a few years, then paying your penalty may still be worthwhile.

Why Lenders Charge Prepayment Penalties

Lenders charge prepayment penalties to provide a borrower with a disincentive for paying off a loan ahead of time, which would cause the lenders to lose out on interest income. Lenders have to commit considerable time to evaluate a borrower and underwrite the loan. Without prepayment provisions, a borrower can just refinance as soon as they find a better rate.

Having a prepayment penalty built into a loan doesn’t prevent borrowers from paying off a loan or refinancing, but it does give them even more reason to review loan documents carefully before deciding on a lender or a loan.