Definition & Meaning:

You'd think that banks would be happy if you paid off a loan you had with them early. Unfortunately, they aren't and to stop their customers from paying off a loan earlier than they originally agreed to do, they make anyone who does pay a financial penalty. Banks call this financial penalty for paying off a loan early, 'redemption penalties'. But why would they do this?

It doesn't seem to make any sense. In fact, it makes perfect sense from the bank's perspective. When a bank gives anybody a loan, they calculate the interest rate they will charge them based on the person's credit history and situation (the risk of you defaulting/not paying it back) and on the repayment period of the loan (the amount of time you have agreed to repay the loan to them).

Generally, banks or lending institutions charge a lower interest rate on loans which take longer to be paid off. This is because they have more years to earn interest from the loan. So, if a customer wants to repay a loan earlier than what they agreed to when they took out the loan (e.g. repay a loan in 3 years instead of 5 years), the bank or lending institution will lose the interest they would have earned if the customer had continued with the agreed repayment period (e.g. a loss of 2 years of interest).

This is why bank charge 'redemption penalties' to any of their customers who want to repay a loan early. It is a way to recover some of the interest they would have earned if the customer paid off the loan in the time frame they had originally agreed to. Each has bank calculates the 'redemption penalties' that its customers have to pay differently. To find out about how much they would be, you should either speak with the bank or look in the terms and conditions in the loan contract.

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Related Vocabulary:

Annual Percentage Rate, Preferential Interest Rate, The Principal.

To learn more vocabulary connected to loans, you can do a free online exercise on bank loan vocabulary.