Prepayment Penalty

Financial Dictionary -> Loans -> Prepayment Penalty

Prepayment Penalty is a term usually used to describe the early payment of a loan or mortgage, but can also be used to refer to any form of prepaid credit, such as prepaid credit cards or things like travelers checks.

With the situation of a mortgage or a loan, a prepayment is simply the early repayment or complete repayment of the loan or mortgage before the due dates laid out in the agreement. Examples of this could be several of the monthly amounts being repaid in only one month, or the whole remaining debt on the loan repaid several years before its maturity date. There are several reasons why a loan or mortgage holder would make a prepayment, the most obvious being to get out of debt as quickly as possible. No one likes to be indebted. This might seem like a positive thing on paper, to repay all the money you borrowed in a timely fashion, however most financial institutions are against this and enforce a penalty if you want to settle a debt before the agreed date.

Lenders look at a loan as the steady repayment of money with interest over a set period of time. This interest is calculated or estimated (depending on whether it is variable or fixed), so they have a rough idea of what profit they will make. Paying all of this off early often means they see a reduction in the amount of interest and therefore a loss in profit. The prepayment penalty is simply a way of countering this loss.

The exact calculation for prepayment penalties vary from lender to lender, although a common formula is taking the current interest rate and applying it to 80 percent of the principal amount and then multiplying the interest by 6 months, arriving at the penalty amount. This still will not over the loss in interest, so some lenders do not even offer prepayment as an option.