What Is a Prepayment Risk?

Lenders assess prepayment risk before they issue your loan quote. Basically, the lender decides on an interest rate that will generate the returns they need in order to take the risk of extending you a loan. If there is a chance you will prepay the loan, you may not pay the full interest required in order for the lender to generate the desired profit. Lenders reduce the flexibility of loans that have a high prepayment risk. This can mean a few things:

  • Your loan contract may pre-set very high prepayment penalties in order to dissuade you from prepaying the loan.
  • Your loan may be structured so you are paying toward the interest for only a number of years, meaning you will have already paid interest on the entire loan if you decide to prepay, and you will not save any money in doing so.
  • Your lender may not agree to a long-term loan in order to hedge against the chance you will be able to pay for the loan before it matures.
  • Your lender may require high monthly payments from you in order to accomplish the shorter loan term without reducing the limits of the loan.