Definition of 'Prepayment Penalty'
A clause in a mortgage contract that says if the mortgage is prepaid within a certain time period, a penalty will be assessed. The penalty is usually based on percentage of the remaining mortgage balance or a certain number of months worth of interest.
A prepayment penalty that applies to both the sale of a home and a refinancing transaction is called a "hard" prepayment penalty. A prepayment penalty that applies to refinancing only is called a "soft" prepayment penalty.
Investopedia explains 'Prepayment Penalty'
Lenders write prepayment penalties into mortgage contracts to compensate for prepayment risk. As the incentive for a borrower to refinance a subprime mortgage is high, many subprime mortgages have prepayment penalties.
A borrower should be aware of the risks associated with a prepayment penalty. A prepayment penalty can substantially increase the cost of refinancing a mortgage when it would otherwise be economical.