A prepayment penalty is a monetary penalty enforced upon a borrower when he or she pays a loan off earlier than was originally agreed. Loaning institutions enforce a prepayment penalty in order to guarantee they make a certain amount of money from loaning money to a borrower. Over the years, this type of penalty has been subject to great debate. As a result, not all loans have this as a requirement.

Those who support the prepayment penalty practice argue that if a person takes out a loan, he or she is agreeing to pay a certain amount of interest over a certain amount of time. If the client pays the loan off sooner than originally agreed, there is less interest to pay. In this case, the lending institution stands to lose money on the original.

Many lending institutions attach a prepayment penalty to a loan because loan refinancing has become relatively commonplace. If a consumer takes out a loan, pays on it for a period of time, and then refinances at a lower interest rate, he or she saves money. The lending institution that provided the original loan, however, loses out on the money that would have been earned from interest payments.

The specifics of a prepayment penalty vary from one lender to another. One type of prepayment penalty is referred to as a soft prepay. This type of prepayment penalty is waived if the source of the original loan, such as a home, is sold. In this case, the penalty is only enforced if the loan is refinanced. This type of prepayment penalty is considered to be an incentive for customers who do not plan on refinancing, while still protecting the original lending institution.

According to American Finance, the most common prepayment penalty is the following formula: six months worth of interest on 80% of the principal balance is owed at the time of prepayment. This means the prepayment penalty on a loan with an outstanding principal balance of 100,000 US dollars (USD) and an interest rate of 8% would be approximately 3,200 USD.