What Is a Prepayment Privilege?

The term prepayment privilege refers to the right a consumer has to pay part or all of a debt prior to its maturity or ahead of schedule, usually without the risk of incurring any penalties.

Prepayment privileges are often associated with mortgages or automobile loans. Information about prepayment privileges is normally included in the lender's contract. Consumers are able to save money by using prepayment privileges since they avoid paying interest charges.

Key Takeaways

  • A prepayment privilege allows a consumer to pay part or all of a debt before it matures or ahead of schedule.
  • Prepayment privileges are generally associated with mortgages and car loans.
  • Lenders that don't permit prepayment privileges charge prepayment penalties, which allow them to recoup any money they would earn with interest charges.
  • Information on prepayments, privileges, and penalties are outlined in lender contracts.

How Prepayment Privileges Work

Lenders are very specific when it comes to their borrowing terms and conditions. They must legally outline specifics about charges, penalties, payment schedules, interest rates, and any other key details that affect the borrower. This includes any information about prepayment—the payment of a debt before it matures or comes due.

Prepayments are common for long-term debt vehicles such as mortgages and car loans, although lenders normally provide details about how they treat prepayments for any type of debt.

As outlined in lender contracts, prepayment privileges allow borrowers to make lump-sum payments toward their principal balance or to pay off their accounts in full before they come due or before they mature. Some accounts allow borrowers to make prepayments at any time, while others limit how much a consumer may prepay on an annual basis.

As noted above, borrowers are able to save a lot of money—money they normally would spend on interest charges—by taking advantage of prepayment privileges. For instance, a lender may allow borrowers to put down $10,000 to pay down their mortgage every year. This amount is in addition to their regular monthly mortgage payments. This lump-sum payment decreases the mortgage, therefore cutting down the amount of interest the mortgagor pays in the future.

Special Considerations

Fixed-income securities that incorporate prepayment privileges are considered riskier to the debt issuer because they don't know when their cash flow will start coming in. Prepayment tends to occur when interest rates are low, and mortgage refinancing is viewed as favorable.

For banks seeking to balance their assets with their liabilities, the early retirement of credit facilities can significantly affect their risk profiles. However, Congress prohibits banks from adding prepayment penalties to credit products such as mortgages to encourage housing ownership and protect consumers.

A prepayment privilege also rises for callable bonds. Companies that want to issue debt in the form of a bond can add a call feature allowing them to call back the outstanding debt if they worry that interest rates will fall after issuance. The call is a right, but not an obligation, for the issuer.

In return for this right, a callable bond's coupon or interest rate is set higher than a noncallable bond's coupon rate. The extra interest on a callable bond compensates bondholders for accepting the added risk a bond with a rich coupon will be prepaid before its stated maturity date.

This is particularly aggravating for bondholders during a falling interest rate environment, but that's the risk that comes with receiving a higher-yielding bond. In contrast to a mortgage, a callable bond generally carries a prepayment penalty in the form of a call premium, which is the added dollar premium a callable bond settles at over the bond's par value.

Be sure to ask your lender or review your contract about prepayment information.

Prepayment Privileges vs. Prepayment Penalties

Prepayment privileges are the opposite of prepayment penalties. Prepayment penalties are fees or charges imposed on borrowers by lenders for paying off an account prior to its maturity. They may be a set dollar amount or a certain percentage of the principal balance.

Charging prepayment penalties allows lenders the ability to recoup any money they would have earned in interest. Borrowers should ask lenders their policies about prepayments before making any lump-sum payments or thoroughly review their contracts to avoid any penalties.