In which situation would a prepayment penalty generally be permissible?

A prepayment penalty is a fee charged to a borrower for paying off their loan early, and it is generally permissible under specific conditions as dictated by state and federal regulations. In this context, when a borrower prepares to pay off their mortgage two years after closing, it is common for loans to include a prepayment penalty during the initial years of the mortgage term.

Often, lenders impose these penalties in the early years to protect their investment and ensure they receive a certain amount of interest. This is especially relevant for fixed-rate loans, where the lender is depending on interest payments over a set period. As the loan ages, the rationale for needing a prepayment penalty decreases, since the lender has already collected a significant amount of interest.

In contrast, if a borrower prepays the mortgage one month after closing or changes loan terms right before closing, a prepayment penalty wouldn't generally apply, as this timing usually falls outside the normal scope of such penalties. Foreclosure situations also do not usually involve prepayment penalties, as lenders are primarily concerned with recovering their outstanding balance under such circumstances.