A “pre-payment penalty” is a penalty, or a charge, assessed against a borrower by a lender for the privilege of paying off a loan early. Unless a lender agrees or unless a statute applies, lenders in California aren’t obligated to accept early payoff on a loan. Instead, in some cases a lender can charge a penalty to a borrower who wants to pay their loan off early. Such a penalty is commonly known as a “pre-payment penalty.”
California law provides a number of protections for borrowers who have loans secured by residential properties. This is especially true where a borrower actually lives in the property. For example, if a single family residential home is occupied by the borrower, then the law provides that most such borrowers can prepay their loan balance at any time, regardless of what the loan documents provide. In most cases the lender on such a loan will be absolutely barred from refusing to accept an early loan payoff. Such an early loan payoff can be very important to a borrower who wants to refinance, or who needs to move and who wants to pay off their loan early. However, most lenders on residential loans can still charge a pre-payment penalty if the borrower pays a loan off early. The amount of the penalty and the borrower’s ability to pay off early depends on several things, such as the terms of the loan documents, whether the borrower actually lives in the property, and whether or not the loan was negotiated by a real estate broker.
If a borrower is an owner-occupant of a single family residential property, then in most cases that borrower will be able to pre-pay up to 20 percent of the loan balance in any given 12 month period. The law provides that in most cases this pre-payment can be made without penalty, regardless of what the loan documents say about pre-payment penalties. In these cases, the borrower can also pre-pay more than 20% of the loan balance, but if the borrower pre-pays more than 20% in any given 12 month period, then the lender can charge a penalty that is not more than six months’ worth of interest payments. In such a situation, the borrower still gets to pay 20% of the loan balance without penalty, and only the prepaid amount over 20% is subject to the six months of interest penalty. After five years, the lender isn’t entitled to receive any pre-payment penalty at all, even if the borrower pays off more than 20% of the loan balance in any given year.
Different rules apply if the loan was negotiated by a real estate broker or if the borrower doesn’t live in the property. Different rules also apply if the property consists of five or more dwelling units. And if a borrower pre-pays a loan after the California Governor has declared a state of emergency, then in some cases it’s possible that no pre-payment penalty may be due at all.
Most of the pre-payment penalty protections that apply to residential property don’t apply to commercial or industrial property. As a result, pre-payment penalties on commercial or industrial loans can be surprisingly high.
After litigating for more than 30 years, Robert Jacobs now mediates challenging real estate, business, construction, personal injury, trust and probate cases. In 2020 he served as Chair of the Contra Costa County Bar Association ADR section and Co-Chair of the Alameda County Bar Association ADR section. Since 2017 he has served as one of the update authors for the CEB treatise Real Property Remedies and Damages and is a co-author of CEB Practitioner (Real Property). He holds an AV rating from Martindale-Hubbell and is a designated SuperLawyer. Mr. Jacobs received his mediator training from Northwestern University in Chicago, Illinois.