A pre-payment penalty is the amount set by the lender as a penalty to the borrower for paying off the loan before it matures.  The prepayment penalty is intended by the lender to recover a portion of interest that the lender had planned to earn when the loan was made.  It covers the lender for initial costs to set up the loan, to service it and to carry it in the early years of high risk. 

Some states limit the pre-payment penalties a lender may charge and other states prohibit them altogether.  To be on the safe side, make sure you tell your lender you do not want a pre-payment penalty with your loan. 

Typical language concerning pre-payment could be as follows: Additional principal payments may be made with any monthly installment, but prepayments made in any calendar year in excess of 20 percent of the original amount of this note shall be subject to a charge of percent of such prepayments.”  Some lenders will waive the penalty if the borrower finances his/her next loan with the same lender.