Prepayment Penalty

A clause in a mortgage contract that says if the mortgage is prepaid within a certain time period, a penalty will be assessed. The penalty is usually based on percentage of the remaining mortgage balance or a certain number of months worth of interest.

A prepayment penalty that applies to both the sale of a home and a refinancing transaction is called a “hard” prepayment penalty. A prepayment penalty that applies to refinancing only is called a “soft” prepayment penalty.

Investopedia Says:
Lenders write prepayment penalties into mortgage contracts to compensate for prepayment risk. As the incentive for a borrower to refinance a subprime mortgage is high, many subprime mortgages have prepayment penalties.

A borrower should be aware of the risks associated with a prepayment penalty. A prepayment penalty can substantially increase the cost of refinancing a mortgage when it would otherwise be economical.

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Fee paid to a lender for the privilege of paying off a loan prior to maturity. A prepayment penalty, which may decline in the years after a mortgage was originally booked, is intended to compensate the lender for loss of income in future years. These are becoming less common as more mortgages are made at adjustable rates that rise or fall according to a Cost of Funds Index or a bank lending rate, such as the six-month Treasury bill rate, Libor or the bank prime rate. See also Assumable Mortgage.

Fees paid by borrowers for the privilege of Retiring a loan early.
Example: Abel borrowed $200,000 last year at 6% interest on a 30-year mortgage. If he pays the remaining Principal now, in one lump sum, there will be a 5% prepayment penalty that amounts to $10,000.