Prepayment Penalty

A prepayment penalty is a charge a lender imposes when a borrower repays a loan, or part of it, before the scheduled due date. Regulation Z defines it twice, once for each kind of credit. For closed-end credit, 12 CFR 1026.32(b)(6)(i) says it means "a charge imposed for paying all or part of the transaction's principal before the date on which the principal is due, other than a waived, bona fide third-party charge that the creditor imposes if the consumer prepays all of the transaction's principal sooner than 36 months after consummation." For open-end credit, 1026.32(b)(6)(ii) means a charge imposed if the consumer terminates the plan before the end of its term, with the same carve-out.

That carve-out matters more than it looks. A lender that waived an appraisal fee or title charge at closing and takes it back if the loan is repaid within 36 months has not imposed a prepayment penalty; it has recovered a third-party cost it had absorbed. A charge that exists purely because the money came back early is a prepayment penalty. The distinction is about what the charge is for, not about what the loan document calls it.

A prepayment penalty is a charge, which makes it a different thing from an unrefunded interest rebate. On a precomputed loan, interest for the whole term is written into the note at the outset, so paying early raises the question of how much of that interest the borrower gets back. That is a refund question, governed by its own federal rules, and published material on amortization sets those out. A prepayment penalty is an affirmative charge on top of what is owed. A borrower can face either, both, or neither, and a loan document that mentions a "prepayment charge" may be describing whichever one applies.

Regulation Z rations mortgage prepayment penalties, and this is the part almost no borrower knows. The rules at 12 CFR 1026.43(g) apply to a covered transaction, meaning a consumer credit transaction secured by a dwelling (1026.43(b)(1)). They work in three layers.

Under (g)(1), such a loan must not include a prepayment penalty unless the penalty is otherwise permitted by law and the transaction has an annual percentage rate that cannot increase after consummation, is a qualified mortgage, and is not a higher-priced mortgage loan as defined in 12 CFR 1026.35(a). In plain terms: no adjustable-rate loan, no subprime-priced loan, and no loan outside the qualified mortgage perimeter may carry one.

Under (g)(2), where a penalty is permitted, it "must not apply after the three-year period following consummation" and "must not exceed the following percentages of the amount of the outstanding loan balance prepaid": 2 percent if incurred during the first two years after consummation, and 1 percent if incurred during the third year. After three years there can be no penalty at all.

Under (g)(3), the creditor "must not offer a consumer a covered transaction with a prepayment penalty unless the creditor also offers the consumer an alternative covered transaction without a prepayment penalty." The alternative has to be genuine: the same type of interest rate, fixed or step-rate, with a rate that cannot increase after consummation; the same loan term; payments meeting the qualified mortgage conditions; points and fees within the qualified mortgage limits; and a good-faith belief by the creditor that the consumer is likely to qualify for it. Where the loan is offered through a mortgage broker, (g)(4) requires the creditor to present the alternative to the broker and to bind the broker by agreement to present it to the consumer. So on a mortgage, a prepayment penalty is something a borrower can decline, usually in exchange for a different rate, and the offer of the penalty-free version is not optional for the lender.

The high-cost mortgage rules approach the same charge from the opposite direction, and the numbers line up. A loan is a high-cost mortgage if, among other tests, "the creditor can charge a prepayment penalty, as defined in paragraph (b)(6) of this section, more than 36 months after consummation or account opening, or prepayment penalties that can exceed, in total, more than 2 percent of the amount prepaid" (12 CFR 1026.32(a)(1)(iii)). And a high-cost mortgage may not include a prepayment penalty at all (1026.32(d)(6)). Read together, the two provisions form a closed loop: a penalty beyond 36 months or above 2 percent makes the loan high-cost, and a high-cost loan may not have a penalty. That is the mechanism by which the outer limits are enforced rather than merely stated.

How to find out whether a loan has one. For closed-end credit generally, 12 CFR 1026.18(k) requires a statement of whether a charge may be imposed for paying the principal early where interest is computed on the unpaid balance, and, where it is not, a statement of whether the borrower is entitled to a rebate of the finance charge on prepayment. On a mortgage, 12 CFR 1026.37(b)(4) puts the answer in the "Loan Terms" table on the Loan Estimate, labeled "Prepayment Penalty", and repeats the definition so the label cannot be applied loosely. Those are the lines to read before signing, because a penalty found afterwards cannot be negotiated.

Outside the dwelling-secured perimeter, Regulation Z's rationing does not reach. 12 CFR 1026.43 applies by its own terms to consumer credit secured by a dwelling, so a car loan, a personal loan or a student loan is governed instead by its contract, by any product-specific federal rule, and by state law, which varies. Whether a particular loan permits a charge for early payoff is therefore a document question rather than a rule question, and the 1026.18(k) disclosure is where a closed-end contract has to answer it.

The loan document states whether a charge applies on early payoff, and if so how it is measured and for how long. When you pay off or pay down the loan inside that window, the servicer adds the charge to the payoff figure. On a mortgage, the size and duration are constrained by Regulation Z, and the lender must have put a version without the charge in front of you at the offer stage.

A hypothetical example on a mortgage. Dalia takes a fixed-rate qualified mortgage of $300,000 that is not a higher-priced mortgage loan, carrying a prepayment penalty within the limits of 12 CFR 1026.43(g)(2). In month 20, which is inside the first two years, she sells and pays the loan off when the outstanding balance is $291,400. The maximum permitted penalty is 2 percent of the amount of the outstanding loan balance prepaid, which is $5,828. Had she paid it off in month 30, inside the third year, the ceiling would be 1 percent, or $2,914. In month 37 there could be no penalty at all, because the charge must not apply after the three-year period following consummation.

A second hypothetical, showing what the alternative-offer rule is worth. Suppose the penalty-bearing loan was offered at 6.25% and the required alternative without a penalty at 6.50%, on the same 30-year fixed term. On $300,000 the quarter point costs Dalia roughly $49 a month for as long as she keeps the loan, since both payments are fixed. Twenty months of that difference is about $980, against a potential $5,828 charge if she sells early. Which offer is better depends entirely on how long she expects to keep the loan, which is why the regulation requires both to be on the table rather than requiring one of them to be cheaper.

Pros (of a loan that carries one)

• The lender is compensated for early repayment risk and can price the loan lower in exchange, which is a real saving for a borrower who keeps the loan.
• On a mortgage the charge is bounded by regulation rather than by negotiation, so the worst case is knowable before signing.
• The alternative-offer requirement means the penalty version has to compete against a penalty-free version of the same loan, which makes the trade explicit.

Cons

• It penalizes exactly the events people cannot predict: a sale, a job move, an inheritance, or a fall in rates that makes refinancing sensible.
• It can convert a beneficial refinance into a losing one, since the charge is paid up front and the saving arrives monthly.
• Outside dwelling-secured lending, the federal size and duration limits do not apply, so the contract and state law decide what is permitted.
• The charge is easy to miss at signing, because it appears as a single line item on a disclosure among many.