What is a prepayment penalty?

A prepayment penalty is specifically a fee that a lender charges a borrower for paying off a loan before its scheduled maturity date. This charge is designed to compensate the lender for the interest income they lose when a borrower pays off a loan early. Lenders often anticipate a certain number of interest payments over the life of the loan; if the loan is paid off sooner than expected, the lender receives less in interest.

This fee may apply to various types of loans, including mortgages and personal loans, depending on the terms agreed upon in the loan contract. Borrowers should be aware of prepayment penalties when taking out a loan, as they can affect financial planning, especially if early repayment is a possibility.

As for the other options, missing a loan payment incurs a different type of fee, making additional payments is not linked to penalties, and refinancing involves its own costs but is unrelated to prepayment penalties on the original loan. Understanding the specifics of a prepayment penalty helps borrowers make informed decisions about loan agreements and their financial strategies.