What is a Loan Prepayment Penalty?

A loan prepayment penalty is a fee that is instituted by a lender to prevent a borrower from retiring a loan prematurely. The fee is established, as part of the loan agreement as a penalty against a borrower discharging a debt before the lender has had an opportunity to recover their costs associated with extending the loan.

Cost of Money

When a lender determines the amount of interest and fees that it charges on money that it lends to a borrower, it bases that decision on the cost of money in the future. The monthly payments that a borrower makes are designed to pay back the interest on that loan first, which is the income earned by the lender. Prepayment of the loan results in lower interest earnings for lender and a loss connected with the loan.

Many will argue that it does not seem fair for lenders to create a disincentive to borrowers for repaying loans early. The fact is that lending money involves costs and decisions on behalf of the lender to forego certain returns and other present uses of money in order to lend it out. Once that money has been lent in the form of a loan, the interest is the compensation that the lender earns and uses to justify making the loan.

Lender’s Loan Cost Recovery

Prepayment penalties takes into account what interest earnings will be over the course of the loan. As the debt is retired through regular installment payments, the lender recovers its costs associated with lending and realizes profit.  In time the lender makes back its money and some of the earnings, which makes the loan profitable. The penalty acts to help the lender recover at least its cost.

Prepayment Advantage

In some circumstances, it may make sense for a borrower to prepay or retire a loan early. This will mean payment of the penalty but it may be worth it since the prepayment penalty does not represent the total interest that the lender potentially earns. This results in the borrower lowering dramatically the interest rate on the loan and getting out from under the debt early. This also decreases the borrower’s opportunity costs when considering what else they can do with their money.

Compare the Cost

A prepayment penalty should be viewed as a way for the lender to recover costs and an opportunity for borrowers to lower their interest rate. Paying the prepayment penalty may not necessarily represent a bad situation for the borrower, depending on the amount of the penalty. An analysis of the loan’s interest cost over time versus the cost of the penalty will help decide whether it makes sense to pay off the loan early or continue to make regular installment payments.