What does the term "prepayment penalty" refer to?

The term "prepayment penalty" specifically refers to a fee that is charged to a borrower if they pay off their loan early before the scheduled end of the loan term. This penalty is designed to compensate lenders for the loss of interest income they would otherwise have received had the loan remained outstanding for its full term. Such penalties are more common in certain types of loans, like some mortgages or personal loans, where the lender has structured their financial projections based on receiving interest over a specific period.

Understanding this concept is crucial for borrowers to make informed decisions, as it may affect the overall cost of a loan if they plan to pay it off early. It is also important to recognize that not all loans come with a prepayment penalty, so borrowers should carefully review loan agreements. Other options, while related to loan costs, do not define the term "prepayment penalty."