Thinking of paying off a loan early or refinancing it? Before you do, make sure you check your loan agreement for any prepayment premiums. Also known as prepayment penalties, these are fees that lenders charge if you elect to pay your loan off early. Here’s what you need to know about why lenders do this and how prepayment premiums work.

Prepaying Leads to Less Money Made for the Lender

When you get a loan and start making your payments on it, there are two specific things you’re paying, which are:

The loan principal – This is the amount that you borrowed from the lender.
The interest – This is what the lender is charging you for borrowing the money.
Here’s an example – let’s say that you borrow a $5,000 personal loan with an annual percentage rate (APR) of 10 percent. The loan has a two-year term, and you pay $250 per month. Over the course of that two years, you pay the lender $6,000, and they make a $1,000 profit from the interest.

That’s a very basic example, and most loans have other small fees besides interest that get lumped into the APR (such as an origination fee). But it works for explaining prepayment.

If you reach the end of the first year on your personal loan’s term and have some extra money, you could pay the remaining balance off then. Since you only had the loan for one year and not two, the lender is now only making $500 in interest. Their profits have been cut in half.

Lenders charge prepayment premiums to mitigate what they lose if a borrower pays their loan off early. These premiums are more common with larger loan that have longer terms, such as mortgages and business loans, because prepayment on one of those can result in big losses on the interest a lender was expecting to make. They could lose out on years of profits from a borrower choosing to prepay.

How Prepayment Premiums Work

Prepayment premiums are fairly simple. If you pay your loan off early, then you must also pay any prepayment premiums at that time. The exact details will depend on your loan agreement, and you should always find out if a loan will have any prepayment penalties before you agree to it.

With mortgages, there are two types of prepayment premiums, which are soft premiums and hard premiums.

If a mortgage has a soft prepayment premium, then the borrower will only need to pay the premium if they prepay their mortgage by refinancing. The lender can’t charge the premium if the borrower sellers their home and pays off the mortgage that way.

Hard prepayment premiums are stricter. Regardless of whether the borrower refinances their mortgage or sells their home, the lender can charge them the prepayment premium, meaning the borrower has no way to pay early without getting stuck with that penalty.

A common prepayment premium amount for a mortgage is 80 percent of the interest the borrower would have paid over six months. With a large mortgage, this can end up being a considerable amount.

Watch for Prepayment Premiums

Whenever you’re applying for a loan, you should read the contract thoroughly and check for any prepayment premiums. Make sure that you fully understand the terms and how much money the lender will charge you if you decide to prepay, whether that’s through refinancing, selling the asset tied to the loan or simply because you’re financially able to do so.