A prepayment fee is a monetary amount a lender may charge a borrower for repaying a loan in advance of the scheduled payoff date. For example, if a person obtains a 30-year mortgage on a home, but pays the mortgage in full within a couple of years, he has paid the loan off ahead of schedule. While one might think a lender should encourage an early payoff, it actually means the lender makes less money over the life of the loan. Since the borrower is paying the loan early, the lending institution cannot collect the total amount of interest it was expecting. To discourage this, a lender may charge a prepayment fee.
Also called a prepayment penalty, a prepayment fee essentially allows lenders to collect compensation for some of the costs of granting a loan. In many cases, paying a loan ahead of schedule results in a significant loss of profit for a lender. A prepayment fee penalizes the borrower for repaying his loan early, which may discourage some borrowers from paying ahead of time. In some cases, however, a borrower may find it beneficial to pay a loan off early despite such a penalty.
When some people think of prepayment penalties, they think of fees charged for repaying a mortgage early or paying off a car loan faster than agreed. A lender can add a prepayment fee to just about any type of loan, however. For example, a lender may charge a prepayment fee for early repayment of a signature loan as well. This type of fee can be charged for a loan without regard to whether or not the loan is unsecured or secured with collateral.
Despite the fact that lenders typically have the right to charge prepayment fees, they usually cannot do so without a borrower's agreement. In most cases, lenders are required to disclose the details of any prepayment fees they charge in their lending agreements. If a borrower does not agree to pay a prepayment fee, he may negotiate with the lender to have it removed from the contract before he signs it. If the lender refuses to do so, the borrower may decide to either agree to it or seek a loan from a different lender.
Some lenders charge a prepayment fee for early repayments but put a time limit on applying it. For example, a lender may charge a fee if a borrower repays his loan within five years but waive the fee if the borrower repays after the fifth year. Others may not charge a fee for early repayments that amount to only a portion of the loan but charge a fee if the total loan amount is repaid.