Why are prepayment penalties charged?
Most commonly, a prepayment penalty is charged to ensure a specified return on the loan since there is no chance for the lender to be repaid for the costs of originating and purchasing a loan if a loan is retired before the term agreed upon in the loan documents. In other cases, a borrower may elect for a prepayment penalty at closing in return for more attractive terms of repayment. A prepayment penalty may also apply with a loan issued to someone whose credit is under repair and represents a higher risk of default.
In some cases, a borrower may elect for a prepayment penalty at closing in exchange for more attractive terms of repayment, such as a lower interest rate. A prepayment penalty may also apply with a loan issued to someone whose credit is under repair and represents a higher risk of default. In exchange for originating a loan under these circumstances, a lender wants to ensure a certain amount of return over the life of the loan. There is often a financial penalty to the lender if the loan is paid off before its full term. The prepayment penalty helps ensure a specified return on the loan.
