When you are considering taking out a home loan, whether for a purchase or refinance, you should ask your lender whether the product they are offering contains a prepayment penalty clause. It may be that a prepayment penalty makes sense, or not, but it is important that you understand how it works before you sign on the dotted line.  

Just what is a prepayment penalty? It's just interest paid to the lender if the mortgage is paid off before the agreed upon term. The penalty could be anything, depending on the lender but six months worth of interest is pretty common. In many cases the prepayment penalty will apply only during the first two to five years. After that there is no penalty. And some states outlaw them completely or place restrictions on them.  

Prepayment penalties may be "hard" or "soft." Hard means it applies through the entire term and for any type of payoff or prepayment including refinance, sale or early principal payments. A hard prepayment penalty usually means the borrower has poor credit or unstable income. Lenders impose prepayment penalties to reduce their risk - and to insure that they will be able to collect at least a minimum amount on the loan.

A soft prepayment is usually only for 2 to 5 years and does not apply for an early sale, but only if refinanced. They usually allow extra principal payments to be made but there may be some restrictions on how much. 

So, why would borrowers agree to a loan with a prepayment penalty?

If the borrower has poor credit then the lender may not agree to the loan without a prepayment penalty. It's the only way the borrower can get financed. These loans more commonly have a hard penalty.

But why would someone with excellent credit accept such a loan?

To get a lower interest rate!  If the borrowers plan to stay in the home for at least 3 to 5 years, and believe that rates are not likely to go much lower, then they may be able to reduce their long term costs by negotiating a lower rate in return for the prepayment penalty clause, which protects the lender from early payoff.

If you think a loan with a prepayment penalty might work for you, you may want to
ask your lender what's available. In all cases of course, you want to check the numbers and be sure you fully understand what you are signing up for.