What is a prepayment penalty?

A prepayment penalty is a fee that lenders impose on borrowers who pay off their loan early. The rationale behind this penalty is that when borrowers pay early, the lender loses some of the interest revenue that they would have earned if the loan had continued for its full term.

Choosing a charge based on the outstanding balance reflects how prepayment penalties are generally structured. This means that if a borrower decides to pay off their loan before the predetermined end date, the penalty is calculated as a percentage of the remaining principal balance. This method incentivizes borrowers to maintain their loan for the full term, ensuring that lenders receive the expected interest payments.

This understanding is key in real estate transactions, as prepayment penalties can significantly affect a borrower’s decision-making regarding refinancing or selling a property before the loan is fully paid off. It is important to clarify terms like these during the loan origination process to avoid surprises later on.