Prepayment penalty

A prepayment penalty exists because lenders earn their return through interest collected over time, and an early payoff cuts that interest short. The penalty recovers some of the lost yield. It can be structured a few ways: a flat fee, a percentage of the remaining balance, or a sliding scale that shrinks the longer you hold the loan. For example, a penalty might be 3 percent of the outstanding balance in year one, 2 percent in year two, and gone after that. On a $40,000 balance, a 2 percent penalty would cost $800.

For a borrower, this clause shapes how much flexibility you really have. If you expect to refinance or pay off early from a cash windfall, a heavy prepayment penalty can wipe out the savings. Some products instead use interest that is fixed in total dollars regardless of payoff timing, which has a similar effect. Before signing, read how early payoff is treated and ask whether the loan has a soft penalty, a hard penalty, or none. A loan with no prepayment penalty gives you room to refinance into cheaper money later.