What Is Prepayment Penalty?
A fee some lenders charge if you pay off a loan early by refinancing, selling, or making large extra payments.
Definition
A prepayment penalty is a contractual fee triggered when you repay all or a significant portion of a loan ahead of schedule. Lenders charge it to recoup the interest income they expected to earn over the loan's life. Prepayment penalties are common on subprime mortgages, some auto loans, and many business loans. They come in two forms: hard (charged whether you sell or refinance) and soft (charged only if you refinance, not if you sell). The Dodd-Frank Act of 2014 effectively banned prepayment penalties on most conventional residential mortgages, so they are rare on new home loans today. Always read the loan agreement to check before signing.
Example
A small-business loan has a 3-year prepayment penalty equal to 3% of the remaining balance. Paying off $200,000 early in year two triggers a $6,000 fee.