A prepayment penalty is a monetary fee that is assessed to a borrower when he or she pays a loan off earlier than was originally agreed. Credit institutions enforce this in order to guarantee they make a certain amount of money from loaning money to a borrower. Over the years, this type of penalty has been subject to great debate and, as a result, not all loans have this as a requirement.
Those who support the prepayment penalty practice argue that, if a person takes out a loan, he or she is agreeing to pay a certain amount of interest over a certain amount of time. If the client pays the loan off sooner than originally agreed, there is less interest to pay. In this case, the lending institution stands to lose money on the original.
Many lending institutions attach this penalty to a loan because loan refinancing has become relatively commonplace. If a consumer takes out a loan, pays on it for a period of time, and then refinances at a lower interest rate, he or she saves money. The lending institution that provided the original loan, however, loses out on the money that would have been earned from interest payments.
The specifics of a prepayment penalty vary from one lender to another. One type is referred to as a soft prepay, and it is waived if the source of the original loan, such as a home, is sold. In this case, the penalty is only enforced if the loan is refinanced. It is considered to be an incentive for customers who do not plan on refinancing, while still protecting the original lending institution.
According to American Finance, the most common penalty of this type uses the following formula: six months worth of interest on 80% of the principal balance is owed at the time of prepayment. This means the penalty fee on a loan with an outstanding principal balance of $100,000 US dollars (USD) and an interest rate of 8% would be approximately $3,200 USD.