A prepayment penalty is a mortgage provision that states that a penalty, or fee, will be assessed to a borrower if an outstanding liability is paid off before a certain time period. Lenders typically calculate these fees as a percentage of the outstanding loan balance, the cost of lost interest payments, or as a flat fee. For example, if $300,000 of principal is still owed on a mortgage and a lender charges a 2% prepayment penalty, the borrower would owe an additional $6,000 in fees to the lender for the privilege of repaying the loan before its maturity date.
These fees are used in practice to protect a lender from the loss of interest payments that would have been received if the borrower had not prepaid the loan balance early.