What Is a Loan Prepayment Penalty?

A prepayment penalty is a fee that lenders may charge when you pay all or part of your loan early. You're more likely to find a prepayment penalty on a mortgage than on other types of loans.

Before you prepay a loan, know whether this penalty may kick in and how much it could cost you.

Why Do Lenders Charge Prepayment Penalties?

Lenders charge prepayment penalties to protect their investment when lending you money. Your loan agreement will detail when the penalty applies, but it's usually within the first three to five years of the loan.

[Read: Best Mortgage Lenders.]

Lenders make money from the interest they charge on loans. When you prepay a loan, the lender doesn't earn as much interest.

"Lenders charge prepayment penalties to compensate themselves for the interest that they lost out on as a result of a borrower paying the principal of a loan back early," says Emily Stork, a banking and corporate finance associate at the law firm Holland & Hart.

A prepayment penalty also discourages borrowers from paying off loans early.

Which Loans Can Carry Prepayment Fees?

Not every loan has a prepayment fee. This table highlights when a prepayment penalty may apply:

Prepayment penalties may be tacked on when you pay off your loan balance or even pay down a large chunk of the principal. Some mortgage lenders may limit the amount you can prepay toward your loan each year before a penalty applies. For example, you might only be able to prepay 20% of the balance.

Federal and private student loans allow penalty-free prepayment. This is a relief if you're trying to fast-track your student loan repayment.

With business loans, whether it'll cost you extra to prepay depends on the lender and the type of loan. A traditional bank may charge a fee, while an online lender may not, or vice versa. Note that lenders of SBA 7(a) loans don't charge a prepayment penalty on loans with terms of less than 15 years.

Personal loans sometimes carry prepenalty fees, but not always. Stork says you can shop around to find a personal loan with no penalty, but know that the lender may impose stricter loan terms. You could pay a slightly higher interest rate or have to offer some kind of collateral to secure the loan.

How Much Do Prepayment Penalties Cost?

There is no standard amount that lenders will charge you for prepaying a loan. The amount and the conditions that trigger a penalty can vary by loan and by lender. Read the fine print on your loan agreement to know if a prepayment penalty applies and how much it is.

The penalty for mortgages may be a percentage of the interest you would have owed on your loan balance or a percentage of the balance. For instance, your lender could charge you 80% of six months' worth of interest or anywhere from 2% to 5% of the loan balance.

Alternately, lenders may charge a flat dollar amount.

[Read: Best Personal Loans.]

What Are the Benefits of Prepaying a Loan?

Two main advantages are linked to paying off a loan sooner rather than later.

First, you can free up money in your budget when you no longer have a loan payment to worry about. Second, and perhaps more importantly, prepaying a loan can help you save on interest.

Assume, for example, that you have a 30-year $300,000 mortgage at 4.5%. You'd spend $247,218 on interest if you repaid your loan according to the lender's schedule.

Now, assume you pay an extra $150 a month toward the principal on the loan. You could pay it off in 25 years instead of 30 and spend $199,601 on interest, saving nearly $47,000.

The more you pay toward the principal of your loan, either monthly or as a lump sum, the more money you could save. Of course, you have to weigh the interest savings against any penalty fee.

"If the prepayment penalty is low enough, it is possible you come out ahead with the interest saved by paying the loan off early," says Chad Rixse, director of financial planning at Forefront Wealth Partners, a financial advice firm. "The downside is the opposite: The prepayment penalty could be so high that paying off the loan early isn't worth it."

Should You Take a Loan With a Prepayment Fee?

You'll know when a prepayment penalty is the right move, Rixse says, if you find the right balance.

Paying the penalty can make sense when long-term savings or benefits clearly outweigh the fee. But if you have a shorter-term loan or a loan with a relatively low interest rate, the fee may outstrip any savings.

Check whether the lender charges a prepayment penalty when you are shopping for loans. Are you willing to take a loan with this fee?

If so, Stork says, "A lender may be willing to give you a better deal on some of the other terms of the loan, perhaps a somewhat better interest rate, since they know that if you prepay, they will be recouping the interest they otherwise would have.

[Read: Best Student Loan Consolidation and Refinance Companies.]

How Do You Avoid Loan Prepayment Penalties?

If you're in the market for any kind of loan, here's how you can avoid a prepayment fee:

-- Compare lenders carefully. If a lender doesn't disclose on its website whether a prepayment fee applies, contact the lender directly to find out before applying.

-- Read your loan paperwork closely. Lenders must disclose any fees they'll charge you upfront, including prepayment penalties.

-- Know your rights. Remember that you can't be charged a prepayment fee for some loans.

If you end up choosing a loan with a prepayment penalty, plan your payoff timeline carefully. Compare the penalty fee with your interest savings.

If you're near the end of the window when a prepayment fee would apply, you might want to wait for it to pass before you pay off your loan. The interest you'd pay over a month or two may be lower than the fee.