Why Do Prepayment penalties on loans exist?

Personal Loans


6 October 2020

Why Do Prepayment penalties on loans exist?

The loan is a liability and one of the core aspects of life that induces stress and keeps us financially captive. At times, destiny favors some of us and offers a chance to pay off the loan much in advance and feel relieved. Readers who are clearing loans every month, don’t you wish you were fortunate enough? You do, but let’s read about a major pain point, you might not be aware of the prepayment of loans.

What is a Prepayment penalty?

A prepayment penalty in a loan contract clause states that when a borrower pays off the loan entirely or partially before term, a certain amount of penalty is applied on it. This clause helps the lender not lose their interest income that the borrower would have otherwise paid throughout the term. 

The lenders are required to disclose the prepayment penalties before closing on a new loan of any sort. This helps make sure that the borrower is well informed in advance of the consequences that might entail when paying the loan off before term. 

How does a Prepayment Penalty Work?

Prepayment penalties are placed in contracts to help compensate for the cost of lost income by the lender. Given a choice, a lender would rather lend to a borrower that pays exactly on time – not prior, or later – in order to generate maximum income from the interest. It’s why prepayment penalties have traditionally been put in place.

These penalties don’t just come into play when the borrower pays off the entire loan, but some of these also apply if a considerable part of the loan is paid as a single payment. Additionally, prepayment penalties can be used to recoup profits when the loan is advertised with below-average interest.

Lenders may calculate the penalty of the principal of the loan or how much interest remains once you’ve paid off the loan. The fee could also be a fixed amount that was decided upon when the loan was signed.

How To Calculate Prepayment Penalties

As mentioned earlier, the penalties can be calculated in various ways. It mostly depends on the kind of loan one has taken, a small personal loan, a substantial loan, or how the lender calculates it. 

One must check how the penalties are being calculated to know if paying the loan off is beneficial. The various ways to calculate it are as follows:

  1. Interest costs: The lender, in this case, applies the prepayment penalty on the total interest paid by the borrower by the end of the term.
  2. Percentage of balance: Sometimes, a certain percentage of the amount left on loan is taken as the penalty fee. 
  3. Flat fee: Some lenders have a fixed amount of prepayment penalty that the borrowers have to pay regardless of how early they pay the loan. This amount is decided upon before the loan is closed. 

How To Avoid Prepayment Penalty?

The best way to avoid a prepayment penalty is to find a lender who wouldn’t or doesn’t charge a prepayment penalty on your loans. In case that is not difficult, make sure to ask relevant questions like, if it is for a certain number of years or the entire term of the loan? What percentage of the loan is considered for the penalty? 

Besides this, there are other ways to prevent a prepayment penalty. 

  • One can always talk to the lender about paying the loan off early, and you may be able to do it close to the final due date and skip the penalty that way. 
  • Origination of the penalty paperwork can also be checked to see if there’s a possibility of paying a partial amount of the loan without penalty. This way, you can pay off the debt earlier and not incur any penalty. 
  • Perhaps the most important aspect to remember – online platforms like EarlySalary provide loans without prepayment penalties on them. This is one of the great methods that can be used to take personal, educational, or even travel without worrying about paying extra if you’re financially responsible.

The Dos and Don’ts of Prepayment Penalty Clause On Loans

Dos 

  • Accustom yourself with the policies of the lender. It can help you to find banks that don’t charge any penalty at all. For example, the RBI has asked banks not to issue any prepayment penalties on floating home loans. 
  • Make sure to read all the points on the prepayment penalty clause and know the exact terms on it. Also, check if it goes away after a certain number of years.
  • Trust brands like EarlySalary, who reward financial discipline by not levying any prepayment penalties on any of their loans. It’s a far more flexible, sensible way to lake loans!

Don’ts 

  • If you already have a loan with a prepayment penalty, do not just pay it off or try to refinance it without correctly calculating if doing this is going to save you any money after the penalty is applied. 
  • Of course, the best thing to do is not to accept any loan with a penalty clause at all. 

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