Definition
A prepayment penalty charges you if you pay the loan off early (typically within 3-5 years). It protects lenders from losing interest income. Most modern mortgages don't have prepayment penalties, but some ARM products do.
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Prepayment penalties protect the lender's interest income if the borrower pays the loan in full early. Most modern mortgages don't have prepayment penalties. Some ARM loans include them during the fixed period. Borrowers should avoid loans with prepayment penalties.
Pro Tip
Avoid mortgages with prepayment penalties; they limit your flexibility and may be very costly if you need to refinance or sell early.
Example
A loan with a 5-year prepayment penalty clause requires the borrower to pay a penalty if the loan is paid off within 5 years, even through refinancing.