What impact does a pre-payment penalty have on a loan?

A pre-payment penalty is a fee imposed on a borrower if they pay off their loan before a specified period. The correct answer indicates that such a penalty makes paying off the loan early costlier. This financial disincentive is designed to protect lenders, as they rely on the interest income from a loan over its full term. When a borrower pays off a loan early, the lender may lose anticipated interest payments. Consequently, the pre-payment penalty serves to offset this potential loss.

This concept is significant for borrowers to understand because it affects their decision-making regarding loan repayment strategies. If a borrower anticipates the possibility of paying off their loan early, the presence of a pre-payment penalty could deter them from doing so, as it adds an additional financial burden. Considering the long-term cost implications, borrowers need to carefully evaluate loans with pre-payment penalties against their financial goals and repayment plans.