What is a prepayment penalty?

A prepayment penalty is specifically defined as a fee charged to a borrower for paying off their loan before the end of the loan term. When a borrower pays off their mortgage or any other loan earlier than the agreed-upon schedule, the lender may impose this penalty as a way to recoup some of the interest income that is lost due to the early repayment. Lenders often view early repayment as a risk because they anticipated collecting interest over the full term of the loan; thus, the penalty helps deter borrowers from paying off the loan too soon.

In contrast, other fees mentioned do not align with the definition of a prepayment penalty. For instance, fees for taking out a loan typically refer to origination fees, which are charged at the beginning of a loan for processing the application. Charges for late mortgage payments are entirely separate and refer to penalties due to missed deadlines or failure to pay on time. Lastly, fees assessed when refinancing a loan are related to costs incurred when obtaining a new loan to replace the current loan, rather than fees charged for paying off an existing loan early.