A penalty assessed by a lender on a borrower who repays all or part of the principal of a loan before its due date. The reason that banks have prepayment penalties is to compensate for the loss of interest that would have been earned had the loan remained in effect for its full term.

Typically Prepayment Penalties are equivalent to 6 months of mortgage interest or 4-5% of the total loan amount. 2% of conventional mortgages have prepayment penalties while nearly 80% of subprime loans have them.

Types of Prepayment Penalties

Hard Prepay- the penalty occurs regardless of the note being paid off via refinance or sale

Soft Prepay - the penalty occurs only in the event the note is paid off via refinance

 Bankapedia’s Take

While many people deride prepayment penalties as evil, indirectly they allow consumers to pay less up front in closing costs. Let me explain:  Loan Officers earn their commission in one of a two ways, or a combination of both. They earn money either by charging consumers up front in the form of origination fee or in the form of yield spread premium. You can read more about that topic here.  

When getting paid on the back end(Yield Spread Premium) which is commissions paid from the wholesale bank to the lender, the wholesale bank needs to ensure it recoups the money it paid out to the lender. If the banks pays a YSP of 2 points on a $300,000 loan-it is paying out $6k in commissions. If the borrower then sells his home or refinances in the first 6 months, the bank didnt have a chance to recoup that $6k commission it paid out and ends up losing money. Anytime the bank is paying the lender more than 1 pt on the back end of a loan there is a very good chance that is the reason you have a prepayment penalty. if you are in a loan in which you pay a couple of points up front to keep the rate as low as possible you probably do not have a prepay. 

So by outlawing prepayment penalties, you are basically forcing consumers to pay more up front, since lenders are making money one way or another and if you  have taken the YSP avenue away, charging up front is the only means left.