Prepayment Penalty
A fee charged by some lenders when a borrower pays off a loan early, compensating for lost interest income.
What is Prepayment Penalty?
A prepayment penalty is a contractual fee charged when a borrower repays a loan — or a substantial portion of it — before the scheduled maturity date. Lenders include these provisions to recover expected interest income foregone when a loan is paid off early. They are most common in mortgages, auto loans, and some business loans. Prepayment penalties may be structured as a flat fee, a percentage of the outstanding balance, or a declining schedule (e.g., 3% in year 1, 2% in year 2, 1% in year 3). Federal law prohibits prepayment penalties on most modern FHA, VA, and qualified mortgages. Borrowers should confirm the presence of a prepayment clause before signing any loan agreement.
Example
A borrower takes a 5-year auto loan and wins a lottery, wanting to pay off the $20,000 balance in year 2. Their loan agreement includes a 2% prepayment penalty. They owe $400 in fees to pay off early. If they had borrowed from a lender with no prepayment clause, no fee would apply. For mortgages, a prepayment penalty of 2% on a $400,000 balance would cost $8,000 — a significant obstacle to refinancing or selling the home early.
Source: CFPB — Prepayment Penalty