Define prepayment penalty and give a scenario where it might apply.

• A. A charge for paying off a loan early; may apply to certain ARMs or high-cost loans to deter early repayment.
• B. A late payment fee.
• C. A penalty for underpayment.
• D. A tax penalty.

Answer: (D)

A prepayment penalty is a fee charged if you pay off a loan early. It’s meant to compensate the lender for the interest they expected to earn had you kept the loan for its full term, and it helps cover certain administrative costs. This type of penalty is more common with specific ARMs or high-cost or subprime loans, where lenders want to deter paying off the loan before the term ends.

Example: You take out a five-year ARM that includes a 2% prepayment penalty if you refinance or pay off within the first three years. If you sell the property or refinance to a new loan within that period, you’d owe a fee equal to 2% of the outstanding loan balance.

Note that this isn’t a late payment fee, a penalty for underpayment, or a tax penalty—the term describes a charge tied to early payoff of a loan.