Why do lenders dislike early loan repayments?

Question

I've frequently seen references in blogs and articles about how banks and other lending agencies like to refer to people who repay loans on an accelerated schedule as "deadbeats", because they get less interest out of that person. Some institutions even implement early-repayment penalties in debt contracts, a practice that's been outlawed in some places.

But when I think about it, this doesn't make a lick of sense. It seems to me that creditors should regard these "deadbeats" as their very best friends:

• The lender gets their principal back ahead of schedule, improving their liquidity and making them able to loan it out again more quickly, should they wish to.
• By reducing the principal outstanding, the amount at risk in the event of a default is reduced.
• By demonstrating that the borrower has the ability to pay beyond the minimum, the risk of default is reduced.

What's not to like?

Answer 1

The reason that lenders dislike early repayments (known as "prepayments" or "voluntary prepayments") is that most lenders match their assets— the loans they've made to others— with liabilities of their own. This can lead to lenders facing significant interest rate risk. This is important to understand— while default risk is certainly significant, interest rate risk can be very large as well, sometimes greater than default risk.

Consider: a lender loans you money at 6.5% for 30 years to take out a mortgage, and funds this by issuing debt in the secondary market for 10 years at 4%. A recession comes along, the Fed drastically cuts interest rates, and the prevailing interest rate for mortgages drops to 3.5%. You repay your mortgage early by taking out a loan from another lender at 3.5%, and now the original lender has the principal back, but cannot reinvest it at a rate high enough to repay its own interest rate expense. If this happens on a broad enough scale, the lender is now bankrupt, with all that entails. That is why they don't like it.

With regard to prepayment penalties— the option to prepay debt is what is known as a call option, and it's often quite valuable. Prepayment penalties are simply a way for lenders to be compensated for the exercise of that option.

The specific case that you're talking about sounds an awful lot like the way that some credit card lenders feel about consumers who take out loans at low (often zero) "teaser" rates and refinance them before they ever have to pay anything to the lender, which bears its own interest expense in the meantime. That's probably best regarded as a strategy by consumers that takes advantage of lenders who are hoping that the consumers will not repay the debt in time. This hope on the part of lenders can sometimes cross the line into predatory behavior (see, for example, the discussion of teaser rates on mortgages in the Financial Crisis Inquiry Commission report), so the fact that the borrowers and lenders in such a situation aren't particularly fond of one another comes as little surprise.

Answer 2

The fundamental reason, beyond any details about shifting interest rates, is that lenders are in the business of lending money. If you pay off the loan early, then they're doing less business. If you pay off part of the loan, you're paying less interest, which means they have to go out and find another source of income to replace you.

Extreme case, suppose you pay off the full loan the very first day, and they don't charge any fees, it's as if they never made a loan at all. They could have stayed in bed.

The thought of getting out of bed for nothing makes them so angry (I exaggerate) that they may well charge fees for early repayments and/or setting up the loan in the first place, to ensure that (aside from being paid for their capital) they still get paid for their time. You can think of early repayment fees as making up for any part of the cost of their time that they rolled into the interest rate, although that's not all there is to it. Addressing your specific points:

The lender gets their principal back ahead of schedule

So if they can find another customer, they can get back to where they started before you made the early payment. That's not an advantage, that's an opportunity to break even.

the amount at risk in the event of a default is reduced [and] the risk of default is reduced

If they wanted to avoid risk then they could not lend money to you in the first place. They made the loan because they think the interest rate in return for the risk is a good deal. You're ending something they thought was a good deal for them.

Lenders do like people who've demonstrated that they can pay off loans, but mainly because it proves that they might be able to take bigger loans in future and generate more income for the lender. What lenders really want, above all else, is the interest[*]. And who they like, most of all, is people who borrow money from them and make the payments. If you pay off early, you're not that person any more.

So, why do they even let you make early payments? Firstly because in many cases the law says so, and secondly because they have to offer customers enough flexibility that they'll actually take the deal.

This is all in general, of course. There might be specific circumstances where a lender does have a liquidity problem and does want to solve it (in part) by taking as many early repayments as they can. But that's akin to a retailer solving a short-term problem by closing stores: if the solution to your problem is "do less business" then things are pretty bad.

Speaking of the market in general rather than retail lending in particular, there are loans that can't be repaid early under the terms that banks might offer for personal loans. For example, a government acting as a borrower can buy back its bonds on the market, but the terms of the bond don't (usually?) allow it to just "pay off the loan early" by requiring the bold holders (lenders) to give them back in return for the bond's face value. They have to pay the market price.

[*] For a while they used to like above all else the ability to trade and use as capital reserve, obscure derivatives of the loans, for prices and ratings that amounted to a wild-ass-guess and therefore in many cases were way too high ;-) That became suddenly less respectable in 2008.

Answer 3

I'll take the pro-consumer side of the equation. Started payment for my condo with a 148K loan @ 30 years. 2 years and 50K paid down later I was in far better financial shape. After 2 years I refinanced $100K remaining on the loan to a 15 year mortgage. It has not been 6 years yet and I'm already down to owing just $55K. If my projections are right I will pay this loan off at the end of 2017.

Ok how is the lender hurt. I paid interest for 7 of 15 years so the bank still made money. Did they make as much money as they would have had I stayed with a 30 year mortgage product NO! Did they make as much as they would have had I not paid down my 15 year mortgage in 5 years NO! But did the Mortgage company still make a tidy sum even with my 7 year payoof in my eyes yes.

It is a win win if the customer pays early and the bank gets its money back. Ask any of those banks that died due to the sub prime mortgage crisis if they would have rather those true dead beat lenders had prepaid principal rather than defaulting on their loans. The difference between one who prepares and one who defaults is with one you are made whole. Yes you could lose on interest rate mis-match.

Answer 4

Lenders are backing new loans and loaning out more money anticipating "X" amount of returned money on a Loan they bought. When there is a run on the bank and everyone pays their loans off early, or even half of the mortgagee do, then they are likely to have their current assets backing their investments downgraded to B or C paper because they are not fiscally fit. You have to have a large amount of guaranteed Monday coming in a certain rate to be able to loan additional money and make additional loan streams in the future. That is how banks get massive and too big to fail....until they do.

Answer 5

A regular payer is a valuable customer for a bank. Banks can and do pay an introduction fee to third parties (such as Home Improvement companies) to generate new business. If that business terminates early, they have effectively wasted the commission and some of their staff salaries. Back when I bought my first house, interest rates were above 10%. If a customer takes out a mortgage over 25 years they will end up paying 3 times the value of the house before they have finished. Similar egregious deals apply to vehicle finance, except frequently the interest rate is higher and, at the end of the deal, the vehicle is all but worthless.