A prepayment penalty, which is sometimes called a loan acceleration penalty, is a penalty for paying off the entire loan early or, in some cases, even making some payments early. It also should be noted that different states have different rules regulating prepayment penalties. On the other hand, many states, such as Nevada have no restrictions at all, while others like Tennessee leave it up to the parties involved. This means that if the interest rate drops and you want to refinance, you could wind up paying a whopping big penalty that could wipe out any savings you could get from a lower interest rate. However, just because you are making the same payment for 30 years doesn't mean that the profit your lender makes is the same every month.
Mortgages are front-loaded.
That means you are paying more interest at the beginning of the loan than you are at the end. It is not until year 21 of your 30-year mortgage that more than half of your annual payment goes toward the principal instead of the interest. When you pay off the entire loan early, or even add additional money every month to reduce the principal, the lender is losing money that he or she had expected to make when the note was written. This is where prepayment penalties come in. Pridgen says that while they are not as common as they used to be, you are more likely to run into them when you deal with a bank or a finance company.