When you take out a personal loan, you typically agree to repay it in fixed monthly installments over a specific period, usually between 12 and 60 months. The interest rate is also generally fixed for the entire loan term. Many individuals use a personal loan to consolidate credit card debts.

However, you can pay off the loan early under some loan arrangements. However, before making that final payment, check the loan agreement to see if the lender charges a prepayment penalty for paying the personal loan early. If so, you want to calculate the penalty amount and compare it to the interest expense savings by paying the balance early.

This article will discuss the prepayment penalty and how to weigh your options.

What is a Prepayment Penalty?

A prepayment penalty is an additional fee that some lenders charge if you pay off your loan before the end of its term. Lenders may charge this penalty to partially compensate themselves for the interest they would have earned had you continued making regular payments for the entire loan duration.

For example, assume you borrow $10,000 with an annual percentage rate (APR) of 16% over a 60-month term. Your monthly payment is $243. If you make all 60 payments, the total interest expense paid to the lender will be $4,590. However, after making the first 12 payments, you want to pay off the remaining balance in the same month. You are paying off the debt four years in advance, so how does this impact you and the lender?

After making 12 months of payments, you’ve sent the lender a total of $2,916 ($243 times 12 months), which included interest of $1,498.91. By paying off the balance early, the lender is losing $3,091.09 of future interest income ($4,590 minus $1,498.91).

Under the loan terms, the lender charges a flat fee prepayment penalty of $500. If you decide to pay the loan balance early, you’ll save $3,091.09 of interest expense, but you owe the lender the $500 fee. Because the prepayment penalty fee is substantially less than the total interest expense, it makes financial sense for you to pay the loan early. Your net savings are $2,591.09 ($3,091.09 minus $500).

Types of Prepayment Penalties

Prepayment penalties vary in how they are calculated and structured. In most personal loan arrangements, there are no prepayment penalties. However, if your loan arrangement does have a prepayment penalty in the contract, it may be structured as one of the following:

Flat Fee

Some lenders charge a flat fee for paying off your loan early, regardless of how much time remains on the loan term. For example, the lender may charge a flat fee of $250 if you repay your loan before the end of its term. The flat fee may be the same regardless of when you prepay the loan.

Percentage of Remaining Balance

Under this arrangement, the lender calculates the prepayment penalty as a percentage of the remaining loan balance. For example, if you originally borrowed $15,000, and now have $8,000 remaining on the loan, the lender may charge a prepayment penalty of 2% on the $8,000. Your prepayment penalty would be $160 (i.e., $8,000 times 2%)

Interest-based Penalty

Some lenders base the prepayment penalty on a certain number of months of interest expense. For instance, they might charge the equivalent of three months of interest if you pay off the loan early.

For example, assume you borrow $10,000 with an interest rate of 16% and a repayment term of 60 months. Your payment is $243 each month. After making payments for 24 months, the outstanding principal balance is now $6,917. You decide to pay off the entire balance this month. Under the loan terms, the lender charges an interest-based prepayment penalty, which is the next three months of interest expense included in your payments.

You look at the loan amortization schedule and note that the interest expense for the following three payments (if you were to make them) would be $94.21, $92.23, and $90.21. In total, the next three months of interest expense is $276.65. This amount serves as your prepayment penalty.

Note that the amount of interest expense calculated would change depending on when you decide to prepay the remaining balance. Interest expense on personal loans is frontloaded (similar to an auto loan or house mortgage), meaning the interest expense incurred in earlier years is higher than in later years.

Sliding Scale Penalty

Sometimes, the prepayment penalty decreases the longer you hold the loan. For example, if you repay the loan within the first year, the penalty might be 5% of the open balance, but if you repay in the third year, the penalty may drop to 2%.

How to Avoid a Prepayment Penalty

The first step to avoid prepayment penalties is to shop for a personal loan where the lender does not require one. If your only option is to borrow funds where a prepayment is required, there are some things you can consider.

Negotiate with the Lender

If your current loan includes a prepayment penalty, you can ask the lender to waive it or agree to a reduced prepayment penalty amount. Even though they may not waive the penalty entirely, getting a reduced amount is beneficial.

Make Extra Payments and NOT a Full Payoff

Some loans allow you to make extra payments without triggering the prepayment penalty if you don’t pay off the entire balance. By making extra payments to reduce the principal balance, you can save on interest expense and avoid the prepayment penalty.

Conclusion

If a personal loan is the right move for you, paying off that loan ahead of schedule can be a great way to save on interest and get out of debt faster; however, it may come with hidden costs.

Not all personal loans come with prepayment penalties. If your loan includes a prepayment penalty, calculate whether paying off the loan early still makes financial sense after accounting for the penalty fee and saved interest expense.