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A prepayment penalty is a fee that lenders impose on borrowers who pay off their loans early. The primary purpose of this penalty is to discourage early payment of loans. When a borrower pays off a loan before its scheduled term, the lender may lose out on anticipated interest income, as interest is typically calculated over the entire term of the loan. By implementing a prepayment penalty, lenders encourage borrowers to stick to the agreed-upon payment schedule, ensuring that the lender receives the expected interest payments. This penalty often serves as a deterrent for borrowers considering refinancing or paying off their loans earlier than planned.

In the context of the other choices, discouraging late payment of loans is typically managed through different means, such as late fees or penalties for missed payments. Borrowers seeking lower rates are more often influenced by market conditions and lender offerings than by prepayment penalties. Loan modifications involve changing the terms of an existing loan, which is a separate process from prepayment scenarios.