What is a prepayment penalty?

A prepayment penalty is a fee charged to borrowers who pay off their loan earlier than the agreed-upon schedule. This penalty is often included in loan agreements to compensate the lender for the potential loss of interest income that they would have received if the borrower had continued making regular payments for the entire term of the loan.

When borrowers pay off their loans early, lenders may not earn the total interest that was originally expected, and therefore, they impose this fee as a way to mitigate that loss. Understanding prepayment penalties is crucial for borrowers, as it can affect their decision to refinance or pay off loans depending on their financial situations.

Other options are centered around different financial concepts, such as bonuses for early repayment, late payment fees, or penalties for not meeting loan terms, which are distinct from the concept of a prepayment penalty. These fees serve different purposes and don't relate to compensating lenders for early loan repayment.