What is Prepayment?

As the name suggests, prepayment is the early repayment of a loan by a borrower. A borrower typically prepays as a result of optional refinancing. The lower interest rates made available by refinancing gives the borrower a greater opportunity to pay ahead of schedule. A prepayment can cover the remaining balance of a loan (prepayment in full) or any upcoming payment that is paid in advance of the predetermined due date (partial prepayment).

There are many different loans and financial obligations that can be settled through prepayment. For example, if you want to pay your rent ahead of time or take care of credit card charges before you receive a statement, you are free to do so. You can also take advantage of prepayment on tax forms in order to settle future tax obligations. Oftentimes, if you prepay a loan, you do so through refinancing.

Although prepayment can be helpful if you want to take care of your debts as quickly as possible, it is important to make sure that prepayment is permitted without significant penalty - especially when it comes to major loans such as your mortgage. If the penalties are too high, it may not be worthwhile to pay in advance.

What is a Prepayment Penalty/Premium?

In some cases, you will be penalized for paying early, also known as a prepayment penalty or premium. A prepayment penalty is an additional fee imposed by some loan agreements where a borrower settles a loan before its scheduled date of maturity. The extra fees are typically designed to compensate the lender for the lost interest income, as well as the possibility of refinancing the loan at a lower interest rate. In general, the prepayment premium will be equivalent to three months of interest on the loan, but this may vary depending on your loan agreement.

In terms of mortgages, since the incentive for a borrower to refinance a subprime mortgage is high, subprime mortgages often have sizeable prepayment penalties. Essentially, lenders want to decrease the likelihood of a borrower paying early by charging extra fees. It is important to do your homework when it comes to prepayment penalties, because it can significantly increase the cost of refinancing a mortgage.

Prepayment premiums are currently only allowed in 36 states and the District of Columbia. However, not every lender within those states imposes penalties. If a lender does charge prepayment penalties, it is often a result of paying your principle on an accelerated schedule, paying off your principle at once, or refinancing the original loan.

The premium amount varies from loan to loan, but it is often a small percentage of the amount of money you borrowed or the equivalent of several months' mortgage payments. As a result, you must determine whether the amount of money you save in finance charges by paying early or refinancing outweighs the prepayment penalty.