Loans are something most people do because they have to and not because they want to. Whether it’s to purchase a car, home or other need, loans are a necessary evil.
You would think paying off a loan ahead of time would be a great way to save money, and it is unless there’s a prepayment penalty.
Many loans, especially long term ones, include a penalty for paying off a loan early. It may sound counterintuitive for a bank to charge you for paying off a loan, but it’s a common practice.
Let us tell you why banks need these penalties and what other issues pop up when paying off your loan early.
How Banks Make Money from Loans
A bank is not a non-profit business. It has employees and shareholders that need profit to survive. When they provide the best personal loans, the payments include interest, which is how they make a profit.
For example, if you get a loan for $10,000 and have a 5 percent annual interest rate, then at the end of the loan agreement you pay $10,000 plus $500 every year of the loan. If the agreement was for four years, then the bank made $2,000 in profit over the life of your loan.
When a bank provides millions of dollars in loans every year, then the interest builds up and they make a lot of money.
A Prepayment Penalty Helps Them Recoup Money
While you would love to pay the loan off early because it saves you money, the bank doesn’t. They take this interest into account for yearly profits and paying a loan off early robs them of that interest.
For example, if you paid the previous $10,000 loan off a year early, then the bank loses out on $500 in interest. They want you to keep the standard payment schedule and use prepayment penalties as a way to discourage you from doing it.
The penalty is usually a percentage of the total money still owed. If you pay off the loan, then the penalty makes sure the bank gets at least some of that lost interest back.
Should I Pay a Loan Off Early?
Small loans often don’t have prepayment penalties, but if you’ve got a 30-year mortgage, it likely does. The bank must disclose the penalty in your loan agreement.
If the amount of interest is more than the penalty, then it’s still worth paying it off. Keep in mind it’s still going to add a large chunk to your final payment.
You might also want to pay the loan off early if it makes your life easier to have one less thing to pay for or if it’s part of overall debt consolidation.
Make Your Choice Wisely
The decision to pay a prepayment penalty or to continue with the loan as normal depends on several factors. The penalty can be a substantial amount, but it might be worth it to you if the circumstances are right.