What is a "prepayment penalty"?

A prepayment penalty is defined as a fee charged to borrowers who pay off a mortgage loan early, which is often outlined in the mortgage agreement. This charge is imposed to compensate the lender for the loss of anticipated interest income that would have been earned if the loan had remained in place for its full term. Lenders may utilize prepayment penalties to limit the risks associated with early repayment by ensuring they can recover certain costs or expected profits that would be lost when a borrower refinances or pays off the loan sooner than anticipated.

The concept is particularly relevant in the context of certain mortgage products where the lenders may front-load their earnings, making the prepayment penalty a strategic tool in managing their financial risks. This contrasts with the other options, which address unrelated benefits or penalties associated with mortgage payments.