When you take out a loan, on the surface it may all seem so easy and simple.
You complete a loan application, submit your details, the lender reviews the application, checks your credit history and credit score, and with some banks and lenders, within 24 hours, bam! The money is in your bank account.
While on the surface all appears smooth and easy, beneath there is more going on, more like the terms and conditions of the loan.
How many of us read all the terms and conditions of a loan? Not many. We just look at the amount we are getting, how much the monthly payment is, and the interest rate. But there is more in the terms and conditions than just that.
The T&C’s outline what happens if you miss a payment, default on the loan, and many other aspects that legal need to be disclosed, and for some loans in the terms and conditions it outlines a pre-payment penalty.
What is a Pre-payment Penalty?
When a lender grants a loan, they know how much they are lending, the interest rate, and how much they will receive back in total payments. The loan is like an investment. Lend out £5,000, get back £5,500 or whatever based on the interest rate and term of the loan. The longer the term of a loan, the more interest is paid, and the more the lender earns back on that loan.
A pre-payment penalty, or as it is sometimes referred to as an exit fee, or early exit fee, is a fee or charge you will be assessed and need to pay should you wish to pay the loan off early, or before what would have been the last payment or at the end of loan term.
This fee can be a percentage of the loan, or a fixed payment.
Why do lenders have and use pre-payment penalties? So they do not lose money, or lose as much money as they would by you paying the loan off early, and the lender not earning all the remaining interest on the loan.
You need to aware when you take out a loan of any pre-payment penalties, not that these charges are a bad thing. However, should you later decide or have the means to pay the loan off before the full term of the loan, it can cost you.
In the example of a pre-payment penalty on a mortgage loan, and you wish to re-mortgage your property, possibly for a better interest rate, you need to be aware of any exit fees as these could hinder your re-mortgaging.