TL;DR: A prepayment penalty is a fee charged when a borrower repays a loan earlier than scheduled. It compensates the lender for the interest income lost when a loan is paid off ahead of term. The size and structure of any prepayment penalty are set in the loan agreement.
A prepayment penalty is a charge that applies if a borrower repays all or part of a loan before its scheduled term. Lenders price a facility expecting to earn interest across its full life; early repayment cuts that income short, and a prepayment penalty offsets the shortfall. It is often structured as a percentage of the amount repaid early, sometimes declining the closer the loan is to maturity.
Prepayment terms affect the flexibility of a facility. A company that expects to refinance or repay early, perhaps after a future equity round, should understand the cost of doing so before signing. As with other fees, the right way to compare offers from lenders is to look at the total cost of capital and flexibility, not the headline interest rate alone.
How is a prepayment penalty different from an exit fee? A prepayment penalty specifically applies to early repayment. An exit fee is generally due on repayment regardless of timing. Some agreements combine elements of both, so the loan document is the place to confirm.
Can prepayment penalties be negotiated? Often, yes. Step-downs, caps, and carve-outs for certain events are common points of negotiation in a term sheet.
Related terms: Exit Fee · Maturity Date · Term Sheet
