[Seungseop Song's Financial Light] Why Do You Have to Pay Fees Even If You Repay Loans Early?

Finance is difficult. It is filled with confusing terms and complex backstories. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, basic financial knowledge must be the foundation. Therefore, Asia Economy selects one financial term each week and explains it in very simple language. Even if you know nothing about finance, we light the 'fire' of financial understanding with 'light' stories that you can immediately grasp.

[Image source=Yonhap News]

[Asia Economy Reporter Song Seungseop] Expectations that interest rates will rise are gradually gaining strength. But is it always best to pay off debt quickly? It might seem better to repay the principal as soon as possible to reduce interest burden, but that is not necessarily the case. If you repay debt too quickly, you may have to pay a fee. This is called the 'prepayment penalty' or 'early repayment fee.' Why do banks charge customers a fee for repaying debt early?

The prepayment penalty is a fee paid to the financial institution when a loan is repaid before the originally agreed loan period ends. It is a kind of cancellation fee. Depending on the loan terms, loan period, and product, repaying debt early can result in a significant charge.

To understand the existence of the prepayment penalty, you need to understand the basic way banks operate. Banks secure funds (deposits) through customers' deposits and bond issuance. They then lend (credit) these funds to other customers. Banks pay interest to deposit customers and receive interest from loan customers. You can think of it as lending money from customer A's deposit to customer B. The bank's basic way of making a profit is by paying 2% interest to A and receiving 3% interest from B, earning a 1% spread.

Now, suppose customer B took out a 100 million KRW loan at an annual interest rate of 3% with equal principal and interest payments over 20 years but repaid it in just one day. From the bank's perspective, because B repaid the loan quickly, the bank does not receive the expected loan interest. Meanwhile, the bank continues to pay interest to A. In this case, the bank expected about 33 million KRW in interest but only receives about 8,300 KRW by B repaying the loan in one day.

Prepayment Penalty Is Not a Profit Tool but a Kind of 'Penalty'

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In reality, the loss is even greater. Various incidental costs occur when executing a loan. If the loan was applied for at a branch, employee costs (labor costs) are incurred. The bank also pays a stamp tax called 'revenue stamp duty.' This is a tax paid to the government when writing documents related to property rights, and it is shared between the bank and the customer.

In the case of secured loans, appraisal fees and registration fees must also be paid. The 'mortgage registration fee' is a representative example. A mortgage means that if the borrower does not repay the loan, the lender has the right to sell the real estate and receive repayment first. Financial institutions need to assess the value of the collateral in advance and register it as collateral for the bank, which naturally incurs costs. Typically, for a 100 million KRW loan, this costs around 700,000 KRW.

This is why banks claim that the prepayment penalty is not a profit tool but a kind of penalty. Without the prepayment penalty, many customers would repay their loans quickly, causing significant losses for banks.

However, some voices argue that the prepayment penalty hinders consumer choice. It makes it difficult to switch to loans with lower interest rates or repay early to reduce interest burden. There are also concerns about whether the bank's fee structure is reasonably calculated, as it varies widely. Critics say that the costs of loan execution are unfairly passed on to consumers.

The call for traditional banks to lower prepayment penalties is gaining momentum as internet-only banks do not charge prepayment fees. KakaoBank does not charge any prepayment fees on all loan products. K Bank does not charge prepayment fees for credit loan plus or emergency loans for mid- to low-credit customers. For credit loans, fees are waived after one year, and for apartment mortgage loans, fees are waived up to 10% of the original loan amount annually.