The prepayment penalty is used most effectively in a falling interest rate market. If your mortgage is 8% and rates when you decide to sell are 6%, your buyer is not going to want to assume your loan. Lenders know that having 8% loans replaced by 6% loans is not as profitable as continuing the 8% loans, and so they charge a prepayment penalty.
Simply put, a prepayment penalty means that if you pay off or pay down your loan too soon, you pay a penalty. Since there is generally a surge of refinancing as interest rates fall, the lender makes up some of the loss that is incurred by replacing high-interest loans with lower-interest loans.
There is no standard prepayment penalty for all loans. The most common prepayment penalty clauses are reviewed with the specific loans discussed later. When you apply for a loan, always ask if there is a prepayment penalty.