Prepayment Penalty
When exactly lenders demand a prepayment penalty and what is meant by a prepayment penalty are explained in this article. A prepayment penalty in connection with loans is usually charged when the loan is repaid early. Especially with particularly favorable rates, consumer advice centers recommend keeping a close eye on special repayment rights.
Prepayment penalty for loans
A loan is usually limited in time. Lenders and borrowers agree on installments that repay the loan principal plus interest within a fixed timeframe. Borrowers rarely choose financing models with variable interest rates.
The vast majority of loans are taken out with a fixed interest rate for the entire term. This applies whether they are consumer loans for goods, short- and medium-term financing needs in other areas of life, or long-term mortgage financing.
During the contractual term, fixed-rate loans have a constant installment amount and interest rate, providing planning certainty for the borrower. Only the ratio of principal repayment to interest in the installment changes over the course of repayment. The starting point for the interest rate is the market interest rate at the time the contract is concluded.
If this fixed agreement is changed because the borrower repays the outstanding loan amount early due to an unexpected inflow of funds or a refinancing, many banks charge a prepayment penalty.
Loan contract design
The majority of loans are agreements with a fixed interest rate. For the borrower, this means receiving a loan amount that he repays together with interest within a previously agreed period. This is done in monthly installments that cover repayment of the principal and the interest. A prepayment penalty becomes relevant for lenders and borrowers when the contract ends early because the debt is fulfilled ahead of schedule.
The repayment plan is altered and thus the lender’s calculations change. This entails several disadvantages that the lender compensates for with the prepayment penalty. One disadvantage arises because loans are refinanced. When a loan is repaid early, the lender can only reinvest the prematurely available loan amount at the interest rates available at that time.
If the new interest rate is lower than the original rate at the time of contract conclusion, a loss occurs on the reinvestment of the prematurely received repayment amount. This difference is included in the prepayment penalty. The second component of the prepayment penalty can be described as lost profit. The interest that a borrower would have paid over the term with his installments is eliminated by the accelerated full repayment.
After subtracting the compensation that the lender can earn by investing the repayment amount until further use, this difference represents the loss of profit or margin damage. This, too, is included in the prepayment penalty. However, a lender cannot always claim a prepayment penalty in every case.
If the termination of the loan is initiated by the lender himself, only in exceptional cases can a further damage claim be asserted — beyond any default damage that may have arisen — analogous to a prepayment penalty.
Calculation methods and damage limits
The calculation of the prepayment penalty is not left solely to the lender’s discretion. It is subject to fixed rules that balance the interests of creditor and debtor. Lenders calculate the prepayment penalty using the active-active method or the active-passive method. The former determines the loss if the prematurely repaid remaining loan amount flows directly into a new loan transaction.
Depending on the change in the new interest rate, the loss for the borrower is manageable. In practice, however, the active-active method is used less often than the active-passive method. In the latter, the prematurely repaid amount is first reinvested. If the reinvestment interest is lower than in a direct reissuance as a loan amount, the damage amount increases.
For the calculation, the lender determines the returns of the prematurely repaid loan until the end of the term. These are compared with the returns from investing the sum in mortgage bonds. It is calculated which investment amount in mortgage bonds for the duration of the term would be necessary to achieve the profit from the originally agreed loan. The difference is the damage, which — after deducting saved expenses and administrative costs — is reflected in the prepayment penalty. Consideration is also given to one or more theoretically possible special payments that would reduce the loan amount over the term. Special repayments are limited by contract design to annual percentage rates or to maximum payments calculated on the total loan amount. These purely hypothetical payments must also be accounted for.
Compensation amounts for consumer loans are legally limited to a percentage share of 1.0%. If the remaining term was less than one year, the possible prepayment penalty is reduced to 0.5% of the outstanding loan amount. The situation is different for mortgage interest. There is no such percentage limit on the remaining loan amount there. An early repayment of a mortgage can be associated with a considerable prepayment penalty if the remaining term of the mortgage loan is still correspondingly long.
Agreements and economic feasibility calculation
The prepayment penalty is not a mandatory legal requirement. Borrowers who take out a loan can freely raise the question of the costs of an early repayment in negotiations with the lender. Often it depends on the borrower’s negotiating skill whether a prepayment penalty is actually agreed. In some cases, the lender already offers at the time of the loan agreement to accept additional special payments or an early repayment without extra loan costs or with only minor fees.
For borrowers who expect to have sufficient sums to repay the remaining loan during the repayment period, this additional agreement can be worthwhile. There is also the possibility of negotiating the amount of the prepayment penalty while planning the early repayment. Lenders are not restricted by the calculation methods from granting discounts and reducing the calculated amount. Even if a waiver or reduction is not achieved or envisaged, this does not exclude the borrower from repaying or refinancing the loan.
Even despite the prepayment penalty, an early repayment or combination with refinancing can pay off for borrowers. This is especially the case when the loan was concluded with a comparatively high interest rate. If the interest rate level changes in favor of the borrower, refinancing savings lead to precisely calculable benefits. Depending on the loan amount and current low interest rates, the total cost is often clearly below the amount due for the prepayment penalty.
Although the debtor must compensate the original lender first, he can, with the same remaining term, achieve a lower installment through refinancing. It is also possible to agree a shorter overall loan term with the new lender while keeping the installment amount the same. From these perspectives, the prepayment penalty is a component of the economic feasibility calculation for terminating a loan, but it is not fundamentally a reason to rule out changing one’s personal financing model. The greater the difference between the previously contractually agreed interest rates and the currently offered rates, the higher the economic advantage even taking into account any prepayment penalty that may be due.
Mortgage financing
Especially in the area of real estate and construction financing, loans are granted for the long term. In mortgage financing, the borrower remains connected to his bank for many years. This means, conversely, that the loan amount is subject to an interest rate lock for this period. Since it is customary in Germany that credit institutions do not agree variable interest rates for their investments, the bank bears the risk of interest rate fluctuations. To offset this risk, a higher nominal interest rate is agreed in a loan contract than the bank itself bears.
If mortgage financing ends earlier than planned, this can cause a potential loss for the bank. If the prevailing market interest rate is lower than at the time the loan was concluded, a refinancing loss arises. The refinancing loss results from the difference between the lower interest rate, the outstanding debt and the remaining term.
Especially in the area of mortgage financing there are several reasons why the bank must protect itself against loss. For example, a house can be sold despite an outstanding loan. Possible reasons include:
- Insolvency of the borrower
- Relocation due to illness or work
- End of a partnership and simultaneous pursuit of division of assets
- Death of the borrower
- Loss of the income source
Find the best mortgage financing using a calculator
To find out which mortgage financing suits you best, a calculator helps to find the best provider. After all, it is your money. Knowing in advance which bank the mortgage financing is really worthwhile with, a calculator is the best basis. Each bank has its own specifics when calculating loans. Therefore, a calculator can give you the best overview of current offers.
Prepayment penalty calculator
So-called prepayment penalty calculators or simply prepayment calculators are increasingly found on the internet. Calculating prepayment interest is a rather complex process. Therefore, using a prepayment penalty calculator is quite advisable. Any reputable finance tip or financial advisor will consult or at least recommend a prepayment calculator.
In addition to the aspects already mentioned, there is also the so-called margin damage. Banks make their profit by paying lower interest on deposits than they charge for loans. Here the difference — depending on the economic situation — is between about 5 and 15 percent. That is the bank’s margin. Credit institutions need this margin to offset risks, fluctuations and losses. If this margin disappears due to early repayment, this is referred to as margin damage.
A prepayment penalty relates to the combination of margin damage and refinancing loss. A prepayment calculator provides a precise insight into the level of risk for the borrower.
Termination and repayment of a loan
Termination of the loan agreement
Since credit institutions are not obliged to terminate mortgage-backed loans before the end of the fixed interest period, the Federal Court of Justice (BGH) has issued explicit rulings and established a consistent case law on this matter. The Federal Court of Justice (BGH) has stated that in justified individual cases, such as the sale of the property or the expansion of the loan agreement, the bank must agree to the withdrawal of the loan.
Even with a term of more than 10 years, the borrower can terminate the financing after 10 years without having to pay a prepayment penalty.
However, if there are reasons on the part of the lender for an early loan termination, the borrower must pay not only the outstanding debt but also the prepayment penalty. If the borrower is unable to do so, he must seek follow-up financing. If follow-up financing also fails, a change of ownership of the mortgaged property is often the consequence. The prepayment payment is therefore compensation for the bank or the lender. This compensation is a fixed part of the contract and is included in the calculation.
Special repayments of loans
In addition to a simple loan agreement, special repayments can be agreed with the bank or the respective lender. Such provisions depend strongly on the subject of the financing. For the purchase of vehicles, short-term financing is usually preferred. The contract also depends on the loan amount. Depending on how much money the borrower has available, the contract can be structured so that the remaining debt varies.
With the help of a calculator you can compute the remaining debt specified in the contract and — in combination with the interest rate lock — the optimal term. Usually in the final months of the contract the remaining debt or the loan balance will be higher than the normal installment. If a special prepayment calculator is used, this aspect of the financing can be explicitly considered.