Why this matters

Prepayment premiums can turn an otherwise attractive refinance into a money-loser. They’re designed to compensate lenders for lost interest when a loan is repaid early. For homeowners and small-business borrowers, the key is spotting them before you sign — and measuring whether the refinance savings exceed the penalty plus closing costs.

How prepayment premiums commonly appear

  • Residential mortgages: Less common today but still possible on private loans. Penalties are typically a percentage of the outstanding balance (for example, 1–3%) or a set number of months’ interest and often decline or expire after a fixed period (e.g., first 1–5 years). Check the promissory note and the Closing Disclosure/Loan Estimate for exact language. (Source: Consumer Financial Protection Bureau)
  • Commercial loans: More likely to include sophisticated charges such as yield-maintenance or defeasance formulas that approximate the lender’s lost interest over the remaining term.
  • Other loans: Some personal or business loans may include early-payoff fees; terms vary by lender and state law.

Types of prepayment charges

  • Percentage fee: A flat percentage of the unpaid principal (e.g., 2% of remaining balance).
  • Months-of-interest: A charge equal to a specific number of months of interest.
  • Declining schedule: A penalty that reduces each year the loan stays outstanding.
  • Yield maintenance / defeasance: Common on commercial or agency-backed loans; more complex to value.

How to calculate whether a refinance still makes sense

  1. Get the payoff amount and penalty from your current lender.
  2. Add expected refinance closing costs (appraisal, title, origination, etc.). You can compare these against the monthly savings from the new loan.
  3. Compute a simple break-even time: penalty + closing costs ÷ monthly savings = months to recoup. Also run a discounted cash-flow (present-value) calculation if you want a more precise answer.

Example

  • Outstanding balance: $300,000
  • Prepayment premium: 2% = $6,000
  • Closing costs to refinance: $3,000
  • Monthly savings from the new rate: $200

Break-even = ($6,000 + $3,000) ÷ $200 = 45 months (3 years 9 months). If you expect to keep the new loan longer than that, the refinance could be worthwhile.

When prepayment premiums are less likely or restricted

  • Many government-backed loans (and conforming mortgage markets) have limited or no prepayment penalties; state laws and lender policies also affect permissibility. Because rules differ by loan type and location, always check the loan’s written terms and, if needed, consult a local attorney or housing counselor. (Source: CFPB)

Practical steps before you refinance

  • Read the promissory note and mortgage deed: The prepayment clause is the authoritative language.
  • Request a written payoff statement showing any early-payoff charge.
  • Compare the penalty plus closing costs to your expected savings and how long you’ll own the new loan.
  • Ask the current lender if they will waive or reduce the penalty — sometimes possible, especially if you’re refinancing with the same institution.
  • Consider timing: if the penalty declines over time, delaying a refinance by a year or two can remove the fee.
  • See how closing costs interact with savings in our guide to How Closing Costs Change When You Refinance a Mortgage.

When to walk away or renegotiate

If the break-even period is longer than the time you plan to hold the property, or if the penalty plus closing costs consume most of the expected mortgage-interest savings, refinancing may not be the right move. For a deeper look at timing tradeoffs, see Refinance Timing: When Refinancing Raises Costs Instead of Saving Money.

Common mistakes to avoid

  • Failing to request a written payoff quote before locking a new loan.
  • Ignoring state or loan-type restrictions that may prohibit prepayment premiums.
  • Forgetting to include closing costs and PMI/escrow changes in your savings estimates.

Professional tips from practice

In my experience working with homeowners, lenders sometimes agree to buy out a small prepayment fee if you’re refinancing with them — it’s worth asking. Also, build a conservative timeline: if you might sell or refinance again within 3–4 years, use a shorter break-even horizon.

Authoritative sources

Disclaimer

This article is educational and does not constitute personalized financial or legal advice. Rules and availability of prepayment premiums depend on loan type and state law; consult your loan documents, a licensed mortgage professional, or an attorney for advice tailored to your situation.

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