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Perhaps you’ve gotten a raise or a bonus, and you want to pay off the remaining balance on a personal loan. Is that possible? The short answer is “yes” and, in many cases, it can be a wise decision.
After all, when you get extra cash, it can often be beneficial to pay off debt. But, if there’s a prepayment penalty, then this loan payoff may be more costly than what you’d expect.
A prepayment penalty is a provision in a loan agreement that states a penalty will be charged if the loan is paid off within a predetermined time frame, say two years.
This post will review ways to find out if your loan has a prepayment penalty, and how the presence of this penalty could affect your decision about whether or not to pay off the personal loan early.
Also included, is information on avoiding a prepayment penalty in the first place, and suggestions for steps you can consider if you want to pay off a loan that has one.
Related: Credit card refinancing vs consolidation
Overview of prepayment penalties
It may sound strange that a lender would include this kind of penalty in a loan agreement in the first place.
The reason why it sometimes happens, though, is because the lender may want to ensure you’ll pay a certain amount of interest before the loan is paid off. It is an extra fee that, when charged, helps lenders recoup more money from borrowers.
You can find out if you’d be charged with a prepayment penalty by looking at the loan agreement you signed with the lender.
If you have one, the penalty could be in effect for the entire loan term or for a portion of it, depending upon how it’s defined in the loan agreement.
Types of prepayment penalties
Figuring out what your prepayment penalty assessment is can help you weigh the pros and cons of paying off your loan early. First, you can always call the number on your monthly billing statement and ask the servicer what the prepayment penalty assessment is. To confirm this information or to calculate the penalty, here are some suggestions:
• Interest costs: In this case, the lender would base the fee on the interest you would have paid if you made payments over the total term. So, if you paid your loan off one year early, the penalty might be 12 months’ worth of interest.
• Percentage of your remaining balance: This is a common way for prepayment penalties to work on mortgages, for example, and you’d be charged a percentage of what you still owe on your loan.
• Flat fee: Under this scenario, you’d have to pay a predetermined flat fee for your penalty. So, whether you still owed $9,000 on your personal loan or $900, you’d have to pay the same penalty.
Avoiding prepayment penalties
If you don’t want to be saddled with this penalty — and you haven’t yet taken out your loan — then you should look at whether the lender you’re considering charges one or not.
If you’ve already taken out a loan and it does have a prepayment penalty, there are some options. First, you could simply decide not to pay the loan off early.
This means you’ll need to continue to make regular payments on the loan, rather than paying off the balance sooner, but this will allow you to avoid the penalty fee. You could also talk to the lender and ask if the penalty could be waived, but there is no guarantee that this strategy will succeed.
If your prepayment penalty may not be applicable throughout the entire term of the loan, you can determine when the penalty expires. If you’re certain that it already has expired, then you may be able to pay off your remaining balance without this fee.
Or, if the penalty will no longer be applicable in the near future, you could pay off the personal loan once there is no longer a prepayment penalty.
Here’s one more strategy — calculate how much you have remaining in interest payments on your personal loan and compare that to the prepayment penalty. You may find that you’ll still save more by paying the loan off early, even if you do have to pay the prepayment penalty.
If you’re in the market for a personal loan, or will be in the future, and you don’t want a loan with a prepayment penalty, ask your potential lender whether one will be included in the agreement. Thanks to the Truth in Lending Act, lenders must provide you with a document that lists all loan fees, and this includes any prepayment penalties.
Types of personal loans
In general, there are two types of personal loans — secured and unsecured. Secured loans are backed by “collateral,” which could be a car, a house, or an investment account, for example. Unsecured personal loans, on the other hand, are backed only by the borrower’s creditworthiness, with no asset attached to the loan.
You might hear unsecured personal loans referred to as “signature loans,” “good faith loans,” or “character loans.” In general, these are installment loans where you pay back the amount you borrowed at a certain interest rate over a predetermined period of time, called the term.
Personal loan uses
Personal loans can typically be used for a wide range of personal reasons, including:
• Consolidation of credit card balances into a lower-interest loan
• Debt consolidation, which can include credit card balances
• Medical expenses
• Home renovation or repair projects
Let’s say that you’re thinking about consolidating credit card debt into one personal loan. Typically, you’d first total up what you owe on credit cards, and borrow enough money on an unsecured personal loan to pay off all of those credit card balances.
This means you would now make payments on one single personal loan, ideally at a rate that would be lower than the combined rates on your credit cards.
To find out roughly how much you could save, you could use a personal loan calculator. In general, the better credit history you have, the more likely that you’ll be able to get a competitive rate on a personal loan.
Possible benefits of consolidating your credit card debt may include:
• It’s more convenient to make just one monthly payment, versus several of them, and this can make it less likely that you’ll miss making a payment.
• Personal loans can have lower interest rates than credit cards, which can save you money in interest.
It can also make good sense to use a personal loan for home improvements, as just one more example. The benefits of doing so include that you can typically expect to pay less in fees and interest when compared to a credit card.
Another plus: if the personal loan is unsecured, your home is not on the line as collateral for the loan.
While there are benefits to borrowing a personal loan, it might not always be the right financial move for everyone. Personal loans offer a lot of flexibility, but if not borrowed wisely, it can tempt borrowers into a cycle of debt.
For example, when using a personal loan to consolidate credit card debt, it could be appealing to begin charging on the now open credit card limit. But doing so can lead to even more debt, as you’d be paying off the credit card and the personal loan.
The interest rates on personal loans may not be as competitive as other, secured loans. While personal loans can have lower interest rates than credit cards, those rates may still be higher than other secured installment loans like a home equity loan or home equity line of credit (HELOC).
Interest rates will likely vary from lender to lender, as well as based on a borrower’s personal financial history, so it’s important to shop around to find the best interest rate and terms for you.
There may also be fees in addition to prepayment penalties. Some personal loans also charge origination fees. This is the fee charged by the lender to compensate for the cost of processing the loan.
Depending on the lender, the fee is usually a percentage of the loan, either taken out of the amount borrowed, or charged on top of the borrowed amount. Policies will likely vary by lender, so be sure to thoroughly read the details of the loan.
Additionally, personal loans can be an entryway to scams. Be sure to fully vet the lenders to avoid any financial malice. Look for lenders who are registered in your state and have a secure website. Other signs of a scam can be a lender asking for upfront payment or guaranteeing approval without reviewing your credit history.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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