What is a prepayment penalty in mortgage finance?

A prepayment penalty refers to a fee that a borrower must pay if they pay off their loan earlier than the agreed-upon term. This fee is designed to compensate the lender for the interest income they lose when a borrower pays off a mortgage ahead of schedule. Lenders may impose this penalty to protect their investment, as they typically expect to receive interest payments over the entire term of the loan.

In the context of mortgage finance, understanding the implications of prepayment penalties is crucial for borrowers, as they can affect the overall cost of borrowing and the flexibility to refinance or pay off loans without incurring additional costs. This is particularly relevant when considering loan options, as loans with prepayment penalties may seem attractive initially due to lower rates, but could become costly if the borrower plans to sell or refinance the home within a short period.