A lender makes money from interest on the loan and/or early breakage penalties paid by a borrower. If a borrower is stubborn not to pre-pay the mortgage before its maturity then the banks only earning is from the interest and some fees.
Not all the home owner with mortgage complete the full fixed rate term. Because of many reasons people move or downsize or prepay the mortgage. That is a sizable pie of the population.
Once a borrower gets a three or five years fixed mortgage – there is about fifty-fifty chance that he may prepay the mortgage. Once prepaid there will be prepayment penalty. For a fixed rate mortgage it is interest rate differential. The whole concept of interest rate differential is ,mainly based on the idea that the rates will be lower in the future. So, the lender will face some losses in its income while reinvesting the money.
Banks technically face loss in a low rate situation because they have already sold the mortgage to another investor and promised a fixed payment. The promise they made is backed by the promise of the borrower. So for the lender to be able to service their end of the promise – without incurring losses – they charge penalty.
Now, if the rates go up in the future then it will be mostly three months interest. That is not enough for a lender. Although they get the opportunity to reinvest the money at a higher rate of return but more is better.
The most innovative way so far I have seen is used by a bank now.
The bank has a posted rate. Then they give you a discount on the rate. The discount is big enough that it takes the actual rate to the bottom. Now the bank advises the borrower that if he / she somehow breaks the mortgage early then they have to return the whole discounted amount along with the penalty. Sometime the discount is also offered as a cash back.
So, this way even if the rates have gone up in future the lender will make his lions share of the penalty.