Most loans, whatever the type, usually have some form of redemption penalty which is applicable during the course of the loan.
What is a redemption penalty?
A redemption penalty is a charge which is levied, by the lender, on any loan which is repaid prior to the end date of the loan. This could not only apply to full repayment of the loan, but also on partial repayment at any time.
When is it applied?
A redemption penalty may be applied at any time during the term of the loan on full or part repayments, but it is most likely to be applied in the early years of the loan, when the outstanding loan balance is higher. As the term of the loan progresses, the amount of penalty often reduces, usually on the anniversary date of the loan. It may well be the case that the redemption penalty is only applied during the first two or three years of the loan, for example. In such cases, after this time no penalty would be payable. With other loans, a penalty could be payable throughout the term.
Why is it there?
There are always costs incurred by the lender when setting up a loan for an individual and the lender recovers these costs from the borrower over the full term of the loan through the monthly repayments and the interest charged. If the loan was repaid early and no penalty was applied, it could well be that the lender had not fully recovered the initial costs of setting up the loan and would end up making a loss on the transaction. Clearly, this is unacceptable to the lender and therefore redemption penalties are applied to ensure that a profit is made, regardless of when the loan is repaid. This is the reason why these penalties tend to be greater in the early years of the loan.
How much will the penalty be and how is it calculated?
The redemption penalty payable varies greatly from lender to lender, depending on
the type of loan and the term of years. As previously mentioned, it is likely to
be considerably higher during the early years of the loan, particularly where t
he loan is taken out over a long period of time, it could then reduce on a
sliding scale over a number of years (this is especially the case with
mortgage redemption penalties).
The actual level of penalty may be calculated in a number of ways. It could be based
on a percentage of the balance of the loan being repaid. For example: the redemption
penalties on somebody's loan are 5% in the first year, 4% in the second year and
3% in the third year. If the borrower were to repay a lump sum of £10000
in the second year, the penalty would be:
