What is a prepayment penalty?

A prepayment penalty is specifically designed to discourage borrowers from paying off their loans ahead of schedule. This fee is typically applied when a borrower decides to repay all or part of their loan before the agreed-upon maturity date.

Lenders enforce prepayment penalties to protect their investment, as they often rely on the expected interest income generated over the life of the loan. When borrowers pay off their loans early, lenders lose out on future interest payments, which is why they impose this penalty. It acts as a deterrent, encouraging borrowers to adhere to the original repayment schedule.

Understanding this concept is crucial for borrowers to evaluate the true cost of their loan, especially if they anticipate making early payments. Other options do not accurately describe a prepayment penalty. For instance, charging for late payments refers to a different penalty structure, while incentives for early repayment and charges for submitting loan applications pertain to entirely different aspects of loan management.