A prepayment penalty is a fee charged by a lender for repaying a loan early. The reason lenders charge prepayment penalties is that the terms of a loan may not make it profitable for them unless the borrower pays on the loan deep into the life of the loan term. The prepayment penalty both offsets the lost income to the lender by losing the loan income and serves as a disincentive to the borrower to prepay. “No fee” loans often have prepayment penalties as the lender makes its money on the loan by charging higher interest over the life of the loan.
Loans with prepayment penalties may have better terms than those without simply because the loan is less risk to the lender. That said, better terms today may not be better terms tomorrow. As most loans are for 10-30 years, borrowers may regret limiting their refinance or prepayment options down the line.