It is possible to settle a loan early and it usually costs nothing if it is not that the loan has a fixed interest rate. If the loan has this type of interest, you can still repay the loan in advance, but you will then have to pay something called interest rate compensation.
The fact that it costs money to settle a loan when it does not cost to settle a floating loan has to do with how the lender has borrowed the money for your loan. Usually, the lender lends money which they then lend to you. If you have chosen to take out a loan with a fixed interest rate, the lending institution has also borrowed the money with a fixed interest rate.
If you pay back in advance, the lender would have an interest expense that remains in the meantime and they would then incur a loss on your loan. Of course, they are not interested in this, and with the support of the law they can then charge a compensation called interest rate compensation.
What is included in the interest rate differential?
What the lender is entitled to is compensation for the loss they receive if you repay the loan early. This means that you will have to reimburse the lender for the interest they pay themselves. This is an interest rate that is lower than the one you pay.
Not as negative as one might think
Now you can think that it is only negative with interest rate difference compensation, but fortunately there are actually positive aspects as well. If interest rate differentials were not available, the risk for lenders would have been much greater when it comes to loans with a fixed interest rate.
And given that the lenders’ way of managing risks is to raise the interest rate, all loans with a fixed interest rate would have been much more expensive if interest rate differential compensation had not existed. So it is not entirely negative that this compensation exists.
Contact the lender
If you are considering redeeming your tied loan in advance, you should contact the lender to get an accurate estimate of what it would cost to redeem the loan.
When you have this figure, you can then easily decide if it is a good idea for you to settle the loan prematurely despite the interest rate differential. It is not possible to say anything in general whether it is a good idea or not, but all such is governed by one’s own situation.