What is a prepayment penalty — and when might it make sense?

Key takeaways

• Prepayment penalties function as a tradeoff in which borrowers accept less flexibility in exchange for slightly lower mortgage rates.
• State-level restrictions on these penalties shift prepayment costs into higher interest rates for all borrowers and can make lenders less willing to extend certain mortgages.
• “Longevity bonus” structures — offering rewards for keeping a mortgage for a set period — present an alternative framing that makes the underlying tradeoffs more visible to consumers.

When you buy your house, your mortgage is probably going to be the biggest financial agreement you ever sign in your life. Do you wonder about some of the details, and whether they work for or against you?

Let’s look at one detail, which may or may not be part of your mortgage, called a prepayment penalty. It’s often discussed as something to avoid and sometimes prohibited as a way to protect borrowers — but that doesn’t necessarily mean the tradeoff looks the same for every borrower.

To understand whether a prepayment penalty is always a bad thing, it helps to step back and ask a few basic questions together: Why would prepaying a mortgage be a bad thing? Could a prepayment penalty actually be good for a borrower? Could it even be reframed as something a borrower would actually want — by calling it, say, a “longevity bonus”?

Your mortgage says that you’ll pay a certain amount each month (that’s called the “principal and interest” payment, or P&I) for the duration of the mortgage — say, 30 years. “Prepaying” simply means you pay off the mortgage faster than you said you would. If you sell your home before the 30 years is up, the balance of the mortgage is paid off: That’s a prepayment. If you refinance your mortgage, the old one is paid off: That’s a prepayment. (If you make bigger monthly payments than required, you’re prepaying your mortgage a little at a time, but prepayment penalties don’t usually come up in those cases, so we’ll set those aside.)

A prepayment penalty won’t necessarily apply even if it’s in your mortgage contract, so let’s think about a situation in which it would: You got your mortgage in October 2023, when the interest rate was 7.83%.

But then mortgage rates went down, so less than three years later you decided to refinance it, meaning you replace it with a new mortgage at a lower rate. Or, at the lower mortgage rate, you can afford a bigger place, so you sell your first home (paying off the old mortgage) and buy another home with a new mortgage. In those cases, your mortgage contract may charge you an extra fee — the prepayment penalty — usually computed as a small percentage of your remaining mortgage balance.

Let’s take a concrete example: You bought a home costing $375,000 in October 2023, when the interest rate was 7.83%, so your monthly payment was $2,166. In February 2026 you see that mortgage rates have dipped below 6%, so you refinance your mortgage at 5.94%.

You’ve already paid off part of your old mortgage, so the new monthly payment is just $1,787 and the refinancing shaved $4,540 per year off your mortgage payments. Yay! But, since you paid off your mortgage less than three years into it, you’ll pay a prepayment penalty of 1% of the outstanding balance, which means $2,934. (You’re still better off — by $1,606 in the first year of your new mortgage, and by $4,540 every year after that.)

Mechanically, that’s all a prepayment penalty is. The more interesting question is why it exists at all.

From a borrower’s point of view, paying off a mortgage early usually feels like a win. From a lender’s point of view, it’s more complicated.

When a mortgage is originated, the lender expects a long stream of interest payments over the entire duration of your mortgage (such as 30 years). If you pay off your mortgage early, that stream of income payments the lender was expecting ends early. Not only that, but borrowers tend to prepay exactly when (and because) interest rates have come down sharply — because those are the times they can refinance into a lower rate or trade up for a bigger house with the same monthly payment.

So, when you prepay your mortgage the lender gets their money back, but not when they were planning to receive it — and, in fact, just at the time when they’re unlikely to find equally attractive ways to lend it. That’s why lenders think of it as prepayment risk and seek to protect themselves from it. A prepayment penalty doesn’t eliminate prepayment, but it’s a way of getting the borrower to share in some of the risk that prepayment creates for the lender.

Once you see prepayment penalties as a way of managing risk, their connection to interest rates becomes clearer. When lenders have more confidence about how long they’re going to continue receiving those interest payments, they become more willing to lend at lower interest rates. In that sense, a prepayment penalty isn’t just a restriction — it’s part of a bargain. Borrowers accept less flexibility in their mortgage terms, in exchange for a modest reduction in their mortgage rate.

How much lower would the mortgage rate be? It’s hard to tell, but Ed Pinto, the director of the AEI Housing Center, told Congress that it could be 0.4 percentage points or more. Let’s say that, when you bought your house in October 2023, your mortgage rate was 7.43% instead of 7.83%. In that case your monthly payment would be only $2,083 instead of $2,166 — which would put $991 back into your pocket each year.

Whether that bargain is attractive depends a lot on the borrower. Some households expect to stay in their homes for many years and don’t anticipate refinancing: For them, flexibility may have relatively little value, while a lower interest rate matters a great deal. Other borrowers — those early in their careers, those likely to relocate or those who expect to refinance when rates fall — may value flexibility much more highly: For them, a prepayment penalty can be costly, and a higher interest rate right now doesn't look so bad.

The key point is that the value of flexibility isn’t the same for everyone.

Many state governments now restrict or prohibit prepayment penalties, at least for homes used as the borrower’s primary residence. The idea is to ensure that borrowers can adjust their housing and financial decisions without facing a surprise fee. But it’s worth pausing to consider what prohibiting a prepayment does, and does not, accomplish. Banning prepayment penalties doesn’t make prepayment risk disappear: It simply changes how it gets paid for in the mortgage bargain.

When lenders can’t manage prepayment risk directly, by including a prepayment penalty in the mortgage contract, they’ll adjust in other ways, and the adjustments they’ll make will likely look familiar. Mortgage interest rates tend to be slightly higher than they otherwise would be, because that’s the only way left for mortgage lenders to get compensated for bearing the prepayment risk. And lenders are slightly less willing to lend to mortgage borrowers: After all, they can still make loans to, say, corporate borrowers where prepayment penalties aren’t prohibited.

Moreover, the costs of prepayment risk are shared differently across homebuyers. When prepayment is free for everyone, borrowers who keep their mortgages for many years effectively help subsidize those who refinance or move early. The transfer is invisible, but it’s real.

And consider this: Borrowers who refinance frequently or move often — that is, the borrowers who benefit from the flexibility of penalty-free prepayment — tend to be higher-income households. That means that borrowers who stay put — often lower-income households — are likely to pay slightly higher interest rates to compensate lenders for giving all borrowers added flexibility, without actually benefiting from the flexibility they’re helping to fund. This isn’t universal, of course, but it’s a pattern that shows up often enough to matter.

None of this means prohibitions are misguided. It does mean they involve tradeoffs that are easy to overlook.

Much of the discomfort around prepayment penalties comes from how they’re described. A “penalty” feels punitive, even when it’s simply the mirror image of a lower interest rate.

But imagine the same economics framed differently.

Instead of charging a fee for early repayment, a mortgage could offer a longevity bonus — a rebate, rate reduction or cash credit for borrowers who keep the loan for a specified period. Borrowers who prepay early wouldn’t be penalized; they would simply forgo the bonus.

Economically, the outcome is the same. Psychologically, it’s very different. The focus shifts from punishment to reward, and from fear of loss to clarity about what’s being gained.

The broader lesson is that many of the details in your mortgage contract are simply part of a bargain you’re making with your lender. The right to prepay your mortgage, and the flexibility it gives you, is valuable — but it’s not free.

If you think you’re likely to trade up to a bigger house, or refinance to a lower-rate mortgage, you may be perfectly willing to pay a slightly higher mortgage rate now and avoid a prepayment penalty. On the other hand, if you think you’re likely to stay in your house and keep your current mortgage, you may be perfectly willing to include a prepayment penalty in your contract and get a slightly lower mortgage rate in return.

Individual borrowers and lenders can come up with the approach that fits them best. Recognizing the tradeoffs involved suggests there’s room for more thoughtful product design — approaches that balance consumer protection with lower mortgage rates, while making the tradeoffs visible enough for consumers to choose which approach works best for them.

Instead of focusing on whether prepayment penalties should be allowed or prohibited, maybe we should focus on whether “longevity bonuses” should be allowed or prohibited — borrowers might clamor for them!

As affordability pressures continue to shape housing markets, it’s worth exploring structures that help borrowers see those tradeoffs clearly and choose the ones that fit their own circumstances.