What is a prepayment penalty?

A prepayment penalty is a fee imposed by a lender on a borrower who pays off a loan, such as a mortgage, before the scheduled date. This penalty is typically established in the loan agreement to compensate the lender for the potential loss of interest income that would have been earned had the borrower continued to make regular payments over the life of the loan.

Prepayment penalties can be designed in various ways, often calculated based on a percentage of the remaining balance or a certain number of months’ worth of interest. It serves the lender's interest in ensuring that they do not lose out financially on a loan due to early repayment.

Understanding prepayment penalties is crucial for borrowers, as they can influence decisions about refinancing or paying off loans early, particularly if significant fees are involved.