What is a prepayment penalty, and how can it affect early payoff?

• A. A prepayment penalty is a fee charged for paying off a loan before term.
• B. A prepayment penalty lowers the interest rate.
• C. A prepayment penalty is a fee charged for paying off a loan after term.
• D. A prepayment penalty applies to all loans.

Answer: (A)

A prepayment penalty is a fee charged when you pay off a loan before the term ends. The idea behind it is to protect the lender’s expected interest income if you retire the loan early, shortening the period they can earn interest. Because of this, paying off early can cost you more upfront than you might expect, which can reduce or negate the financial benefit of an early payoff. The penalty can be a percentage of the outstanding balance, a fixed amount, or a set number of months’ interest, and it may disappear after a certain period or not apply at all on some loans. It does not lower the interest rate, and not all loans have this penalty, nor does it apply only after the term. This aligns with the described concept: a fee charged for paying off a loan before term.