Short answer: a prepayment penalty is a charge for paying all or part of a loan off before it is due. For a typical installment loan with interest charged on the unpaid balance, federal rules require the lender to state in your loan disclosures whether such a charge may be imposed (Regulation Z). Some lenders cannot charge one at all, including federal credit unions and lenders covered by the Military Lending Act.
Where to find it before you sign
- Look at the Truth in Lending disclosure, the box with the APR, finance charge and payment schedule. It must include a statement on prepayment.
- If interest is charged on the unpaid balance, the statement says whether a charge may be imposed for paying principal early (12 CFR 1026.18(k)(1)).
- If the finance charge is computed another way, for example added up front, the statement says whether you get a rebate of part of the finance charge if you pay early (12 CFR 1026.18(k)(2)). No rebate can work like a penalty.
- Then read the note itself for how a penalty is calculated: a percent of the balance, a number of months of interest, or a flat fee, and whether it ends after a set time.
Who cannot charge a prepayment penalty
| Lender or borrower | Rule |
|---|---|
| Federal credit unions | A member may repay a loan "prior to maturity in whole or in part on any business day without penalty" (12 CFR 701.21(c)(6)). |
| Active duty servicemembers and covered dependents | Under the Military Lending Act a lender may not charge a penalty fee for prepaying all or part of covered consumer credit (32 CFR 232.8(h)). See our MLA guide. |
For other lenders, whether a penalty is allowed depends on the loan contract and state law. The disclosure tells you what your lender does.
The payoff math: is paying early worth it?
Assumptions: $5,000 at 10% APR for 36 months, a payment of $161.34. You want to pay it off after 12 payments. To show the effect, assume a penalty of 2% of the remaining balance; this is an example, not a typical figure.
| Item | Amount |
|---|---|
| Balance after 12 payments | $3,496.29 |
| Interest you would still pay if you kept the loan to the end | $375.77 |
| Example penalty, 2% of the balance | $69.93 |
| Net saving from paying off now, after the penalty | $305.85 |
Because interest is charged on the balance, most of the interest in an installment loan is paid in the early months. The later you pay off, the less interest is left to save, so a penalty takes a bigger share of the saving. See how the balance falls month by month in our payment schedule calculator.
Questions to ask the lender
- Is there any charge for paying the loan off early, or for paying extra each month?
- If I pay extra, does it go to principal right away, or to future payments?
- Is the finance charge computed on the unpaid balance, or added up front? If up front, do I get a rebate if I pay early?
- Compare offers by APR and total cost, and include any penalty in the comparison (APR vs interest rate).
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Disclosure: Modern Lending Solutions is not a lender, loan broker or agent for any lender or loan broker, and does not make credit decisions. Any compensation we receive is paid by participating lenders, only for advertising services. This guide is general information, not financial or legal advice.