Legal Definitions - prepayment penalty

A prepayment penalty is a fee that a lender charges a borrower for paying off a loan earlier than originally scheduled. This clause is typically included in the loan agreement, especially for mortgages or commercial real estate loans, to compensate the lender for the loss of interest income they would have earned if the loan had run its full course.

Lenders impose prepayment penalties to protect their expected returns on investment. When a borrower pays off a loan early, the lender loses out on the future interest payments that were anticipated. The penalty helps to offset this financial impact. The amount of the penalty can vary, often calculated as a percentage of the remaining loan balance or a fixed number of months' interest, and it usually applies only if the loan is paid off within a specific initial period, such as the first few years.

• Example 1: Mortgage Refinancing

  Imagine Maria took out a 30-year mortgage to buy her home. Two years later, interest rates dropped significantly, and Maria decided to refinance her mortgage with a different lender to secure a lower interest rate. Because her original mortgage agreement included a prepayment penalty clause for early payoff within the first five years, her original lender charged her a fee when she paid off the initial loan. This fee compensated the original lender for the interest income they would have received over the remaining 28 years of the loan, which they lost due to Maria's early repayment.

• Example 2: Commercial Property Sale

  Greenwood Developments Inc. secured a 10-year loan to purchase a commercial office building. After only three years, a larger corporation offered to buy the building from Greenwood Developments at a very attractive price. Greenwood Developments decided to sell the property and, in doing so, paid off their commercial loan ahead of schedule. As stipulated in their loan agreement, the lender assessed a prepayment penalty. This penalty served to recover some of the interest income the lender would have earned over the remaining seven years of the loan term, which was forfeited due to Greenwood Developments' early repayment.