What is the basic rule regarding prepayment penalties in covered transactions?

The basic rule regarding prepayment penalties in covered transactions is that a covered transaction typically may not include a prepayment penalty. This stance is primarily established to protect consumers in mortgage lending practices, ensuring that borrowers are not unduly penalized for paying off their loans early. The rationale behind this regulation is to foster a more transparent lending environment, allowing borrowers the freedom to refinance or pay off their loans without incurring additional costs that could hinder their financial flexibility.

In the context of the law, a covered transaction often refers to certain types of loans secured by a borrower's principal dwelling, which are designed to adhere to stringent consumer protections. By prohibiting prepayment penalties, Regulation Z aims to mitigate the risks and financial burdens on borrowers that may arise from such penalties, ultimately promoting more favorable lending terms and enhancing consumer rights.

Given this understanding, the other choices do not align with the regulatory framework. Prepayment penalties are not generally allowed in covered transactions, thus making the assertion that such loans may include them inaccurate. The idea that a prepayment penalty can be avoided implies that they might exist in the first place, which contradicts the rule. Lastly, stating that prepayment penalties are subject to lender discretion overlooks the regulatory limitations that ensure consumer protection in these scenarios.