Prepayment Penalty

What does it mean

A Prepayment Penalty is when the borrower will incur a fee for paying their loan down faster than what is required in the note.  There are various types of Prepayment Penalties.  Some cause a fee for any amount of prepayment and others allow a small amount of prepayment without a fee.  

Why does it matter

Prepayment Penalties are used primarily for three reasons:

1. Matched Funding -If a customer insists on a long term fixed rate loan, a bank may choose to fund the loan by taking out its own loan for a matched period of time from a creditor such as the Federal Home Loan Bank.  This process is called Match Funding, and many times, the bank will have a penalty if it repays the loan sooner than the agreed upon term.  In a Match Funding scenario, a bank will typically give it's customer a prepayment penalty as well.
2. Prevent Refinancing - A prepayment penalty is a strong disincentive for a customer to refinance a loan out of the current bank.
3. Ensure sufficient time to earn a profit - Sometimes a bank will offer such a discounted rate or fee to the customer that it will take a longer period of time for the bank to effectively recoup its costs/lost profit.  To ensure the bank realizes this period of time, a prepayment penalty can be put into place to encourage the loan to stick around.  

Typical Prepayment Penalties will be as follows:

•  5/4/3/2/1
•  Year 1: 5% of loan amount
•  Year 2: 4% of loan amount
•  Year 3: 3% of loan amount
•  Year 4: 2% of loan amount
•  Year 5: 1% of loan amount
•  Year 6+: 0% of loan amount

Other Relevant Terms

• Loan Structure
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