Definition of Prepayment Penalty

A prepayment penalty is a penalty that the borrower will pay when he pays off the remaining mortgage at once to the lender. The lender normally adds the prepayment penalty into the mortgage agreement as a clause. The amount of the prepayment penalty is calculated based on the remaining amount of mortgage principal or a fixed amount.

The reason for including the prepayment penalty clause in a mortgage agreement is to safeguard the risk that the borrower will deprive the lender of any future interest income on the outstanding mortgage. Another reason might be that the borrower wants to sell the property to another party at a profit by early payment of the mortgage.