Ministers were considering introducing annual charges of around 5% on payments above a certain limit to prevent wealthier students avoiding interest charges on the new standard 30-year repayment plans.
The proposals were billed as "progressive" but the Government is dropping them amid fears hundreds of thousands of students would end up losing out.
It has been reported the Lib Dem scheme was scrapped as part of a deal that saw Prime Minister David Cameron back down over Business Secretary Vince Cable's choice of Professor Les Ebdon to head the Office for Fair Access (Offa) despite fierce Conservative opposition.
A Downing Street source told The Telegraph: "The Lib Dems were very keen to appoint Ebdon and we felt very strongly about penalties for early repayment of loans. This is hopefully good news for tens of thousands of families, as well as many Conservative MPs who had raised concerns about the penalties."
From September students will be able to take out loans to cover their annual tuition fees bill of up to £9,000 as well as their living costs.
They will begin to repay the loans once they earn more than £21,000 a year and any outstanding balance will be written off after 30 years.
Consultation on the plans to introduce early penalty fees closed earlier this year and ministers are expected to announce the plans have been dropped next week.
A No 10 spokesman said: "The consultation has now closed and we will come forward with our response shortly."
As the director general of Offa, Prof Ebdon will be responsible for ensuring the introduction of higher tuition fees do not deter students from low-income backgrounds from going to university.
His appointment is said to have been opposed by Education Secretary Michael Gove who is reported to believe that he was more interested in social engineering than promoting excellence in universities.
That view was echoed by Conservatives on the Commons Business, Innovations and Skills Committee, which last week called on the Government to reopen the selection process following a pre-appointment hearing with Prof Ebdon.
Sally Hunt, general secretary of the University and College Union (UCU), said: "Government should be prioritising how to make it easier for poorer families to afford university rather than focusing on yet another policy designed to make life easier for the wealthiest in our society. Today's move exposes once again that we really are not all in this together.
"While no one would condemn any family that sought to pay off their children's debt as fast as possible, today's move simply exposes yet again what an inconsistent mess the higher education reforms are."
Liam Burns, president of the National Union of Students (NUS), said: "Early repayment penalties ultimately risk making the student loans system more regressive, but the issue of whether they should be barred or encouraged is a smoke screen that obscures the truth about paying back earlier than required.
"Paying back early is rarely a rational decision for those who have saved money for college or have a little bit extra to spare and most would be better off investing it in an ISA than handing it to the Student Loans Company.
"Ministers must come clean on student finance to ensure those on low and middle incomes are not duped into chipping away at their outstanding debt even when it rarely makes financial sense to do so, particularly for those who are seeking to get on the housing ladder or start a family.
"In reality graduates shouldn't be able to repay early unless that repayment is over half of what is owed. That way debt adverse, low earning graduates won't be duped into throwing away capital earned early on in life when they might not have had to pay that amount at all."
The think-tank CentreForum, which called on the Government to ditch the plans last year, said the move would help the most "debt averse".
Chief economist Tim Leunig said: "This is the right decision taken for the right reasons. Evidence shows that the students who repay their loans early are not the wealthiest, but the most debt averse.
"Students should not worry about taking a loan from the student loan company. Equally government should not penalise those who want to get out of debt for whatever reason."
Shabana Mahmood, shadow higher education minister, said: "Today we've seen yet another U-turn by a Government whose fees policy is unravelling by the day, creating chaos and confusion for students and universities alike.
"This move will do nothing to make the system fairer. If the Government really wanted to help students now, it could reverse the corporation tax cut for the banks and use the money to help cut fees to a maximum of £6,000. Instead, we have seen student places cut by 15,000 and applications fall by 7.4% compared to 2011.
"That is the difference between Labour, which makes investing in skills and knowledge a priority, and an out of touch Tory-led Government that is restricting opportunity and damaging the future of our economy."
PA
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