Prepayment penalties: The hidden trap in some personal loans

Paying off a loan ahead of schedule can feel like a big financial win. Who doesn’t want to be debt-free sooner?

But if you hope to pay off a personal loan early, there may be a catch: Some lenders may charge a prepayment penalty, which is a fee for paying off the loan before the scheduled term. That cost could eat into — or completely erase — any interest savings you were counting on.

While prepayment penalties are becoming increasingly rare, particularly in personal loans, it’s important to read the fine print before signing any loan agreement to avoid costly surprises.

Personal loans are usually unsecured, meaning you don’t have to provide any form of collateral to qualify. Lenders decide to lend money to you based on your creditworthiness and income. They give you a lump sum of cash and, in return, you repay the loan with interest.

To generate revenue, lenders rely on borrowers to pay interest. If you pay off a loan early, you save money on interest and cut into the lender’s profits. To deter borrowers from accelerating their debt repayment, a lender may charge prepayment penalties. These penalties, sometimes called early payoff fees, can reduce the savings you get when paying off debt ahead of schedule.

When you apply for a personal loan, you can choose a loan term. Your monthly payments are calculated to ensure you make fixed payments for the entire loan term. If you opt to pay off the loan before the end of the original term, a prepayment penalty may apply.

The lender applies the prepayment or early payoff fee as specified in your loan agreement. You might see one of these fee structures:

Percentage-based fee: You pay a percentage of your remaining loan balance. Say you took out a $20,000 loan, and after three years of payments, you have a balance of $9,500. You inherit a lump sum and want to pay off the loan early. Assuming the lender charges a 2% prepayment penalty, you’d pay $190 in fees.
Flat fee: Some lenders charge a flat fee, such as $200, if you pay off the loan early, regardless of your loan balance.
Interest-based fee: With an interest-based penalty, lenders charge you a period of interest for paying off your loan early. For instance, if you pay off the loan a year early, the lender may charge you three months of interest.

Early payoff fees may apply if you repay your remaining balance in full, or if you repay a substantial amount (such as 20% of the remaining balance). Smaller, extra payments are usually exempt from the fee, so you can put a little additional cash toward your debt without penalty.

Where to find details about penalties and fees

By law, lenders are required to disclose all fees they charge, including prepayment penalties. Look for details on prepayment fees in the following documents:

Loan agreement or promissory note: Your loan agreement is the document you sign to obtain a personal loan. Look for terms on the loan like “prepayment,” “early payoff,” or “precomputed interest.”
Truth in Lending Act (TILA) Disclosure: TILA requires lenders to use a standardized format to disclose their terms and fees. Lenders must disclose the finance charges, annual percentage rate (APR), payment information, and fees.
Customer support: If you already have a loan and cannot locate your paperwork, contact the lender’s customer service department. They can tell you what fees may apply if you pay off the loan early.

Related: What’s an origination fee on a personal loan — and how can I avoid it?

Prepayment penalties on personal loans are extremely rare. As personal loans become more popular and more lenders enter the market, there is increased competition for customers, so personal loan companies may reduce their fees to appeal to customers.

Banks, credit unions, and online lenders rarely charge early payoff penalties. In fact, we analyzed 20 major lenders and found that none of them charged prepayment penalties.

Tip: None of the lenders on our list of the 12 best personal loan lenders charge prepayment penalties.

We didn’t find any lender that charged prepayment penalties on unsecured personal loans. One exception is credit-builder loans — a specialized form of lending for those with poor credit. These loans require you to make monthly payments for a set period with the goal of building your credit. However, paying off the loan early can compromise its effectiveness, and you’ll also incur a penalty.

When comparing personal loan offers, prepayment penalties are unlikely to be an issue. But it’s always a good idea to check the fine print before signing a loan agreement to avoid unexpected fees. Review the disclosure for any penalties or fees that the lender may charge, and look for a lender that offers loans without added fees.

Request loan quotes from several lenders to find the best rates and term options. Many lenders have prequalification tools so you can view your options without affecting your credit.

Personal loans rarely have prepayment penalties. Lenders like Lightstream, SoFi, and LendingClub allow borrowers to pay off their loans early without paying an added fee.

Since personal loans rarely have prepayment fees, paying off the loan early is a good way to eliminate debt and save money on interest.

Say you had a $10,000 loan balance at 12% APR, and two years left on your loan term. If you paid off the loan with a $10,000 lump sum, you could save over $1,200 in interest.

Paying off a loan early can have a small, negative impact on your credit. With the account closed, you may damage your credit mix, a factor that affects 10% of your FICO credit score. And, you’ll no longer get credit for on-time monthly payments for that account.

However, paying off the loan ahead of schedule can be worth the decrease in credit score if you’ll save money on interest or reduce your stress over debt.