Watch Out
for Prepayment Penalties
Although a number of states have outlawed them, prepayment
penalties are thriving in one area of the mortgage business – the
subprime industry. But if you don't have a subprime loan doesn't
mean you can breathe easy. About 10% of all ARMs that are
"conforming" in nature have prepayment penalties per Fannie Mae.
What they are...
A
prepayment penalty is basically a fine for paying off your loan early.
Most of the time, prepayment penalties are structured like this: If you
pay off your loan within the first 2 or 3 years, you’ll have to pay a
certain percentage of the loan amount as a fee for the lender agreeing
to allow your loan to be paid off.
While that sounds outrageous, lenders will offer you something in order
to get you to agree to attach a prepayment penalty to the loan, like a
quarter or half point reduction in the interest rate of the loan.
Mostly, prepayment penalties are used to adjust the risks of making the
loan, including the risk that it might be paid off sooner than the
lender expects or the risk that the borrower will pay late or will stop
making mortgage payments altogether.
Prepayment penalties for
homeowners are a huge problem as they are rarely disclosed to the
homeowner in an understandable way. Prepayment penalties are
supposed to be disclosed on the Truth-in-Lending Statement.
Unfortunately most homeowners never receive a properly completed
statement until closing and at that point it may be too late.
Why do Lenders put them on
loans?
By locking the borrower into a tough prepayment penalty, the lender is
trying to guarantee a stream of income for at least 2 or 3 years. Over
the past few years, as interest rates dropped to historic low levels,
the typical 30-year mortgage was paid off in 12 to 18 months, instead of
a more typical 7 to 8 years. As a result, some lenders lost money on
these loans.
An even bigger risk is that the borrower will pay late or stop paying
the mortgage altogether. It’s an accepted fact in the mortgage industry
that borrowers with less than perfect credit are at a greater risk for
foreclosure than borrowers with perfect credit.
That is why prepayment penalties are flourishing in the subprime market,
according to the Mortgage Bankers Association of America (MBA).
Subprime lenders find prepayment penalties a useful way to lessen some
of the risk involved with making subprime loans. Where the
consumer has credit dings, the risk profile of the consumer is
sufficiently high that a prepayment penalty allows the lender to lower
the risk on the loan and make the loan.
In the subprime market, lenders use prepayment penalties in different
ways. If there’s no prepayment penalty, the borrower might pay 1.5
points (a point is one percent of the loan amount) upfront. With a
prepayment penalty, there may be no points.
A
lender might also use a prepayment penalty to help lower a mortgage
interest rate to a level that will allow the borrower to qualify for the
loan.
It Must be Disclosed & It
Must Be Paid!
Although prepayment penalties must be disclosed in writing when applying
for a loan and at the closing, the documents can be tough to read and
understand. While borrowers might understand that a prepayment penalty
precludes them from refinancing the loan within the penalty period, they
often don’t understand that having a prepayment penalty also means they
can’t sell their home without paying the penalty.
When you sell your home, you have to pay off the loan with the proceeds.
But limiting your ability to sell your home is a reality many homeowners
don’t understand until it is too late.
Another problem with prepayment penalties is that they are the
tool of choice for predatory lenders. Instead of using a prepayment
penalty to lessen the risk a higher-risk borrower will go into
foreclosure, a predatory lender will use a tough prepayment penalty to
lock the borrower into bad loan situation and keep him or her there for
years to come.
Are there market abuses? Absolutely. The MBA states that any time you
have a prepayment penalty that was not properly disclosed to the
consumer and was not necessary or required for the transaction it’s an
abuse.
But if you’re the borrower and your lender is telling you that you can’t
get a loan without a prepayment penalty, how do you know it’s an abusive
situation?
According to the MBA, borrowers have to shop around, read
their documents, and understand exactly the prepayment penalty
disclosure: If you have a prepayment penalty attached to your loan, you
cannot pay off the loan before the penalty period is up, or you have
to pay. And, that includes selling your
home.
Beware of Scams!
In one of the most frequent scams, predatory lenders tell borrowers that
their loans do not carry prepayment penalties, then slip the disclosure
paperwork into the myriad of other papers they have to sign at the
closing and hope the borrower doesn’t notice.
That is why you have to read all of the documents before you sign them.
If you were told your loan did not have a prepayment penalty and at the
closing you’re asked to sign a prepayment penalty disclosure, you’re
being railroaded.
And don’t think you’ll be able to get out of your prepayment penalty
later on with a sob story. Lenders have heard it all before. In
addition, prepayment penalties continue with the loan until they expire,
even if your lender sells the servicing rights for your loan to another
company.
When a lender sells a loan, all of the underlying contractual
relationships, duties, responsibilities and rights remain exactly the
same. The only thing that should change is the address to which you’re
paying the loan.
What Can You Do?
The only thing that works against an abusive prepayment penalty
situation is knowledge: You have to know what your credit history
is, what your credit score is, and what your options are before you sign
on the dotted line.
All members on this site have signed a
Residential Mortgage Advocate™ (RMA) commitment to be totally upfront about
their fees, rates and items they will need from you.
Been Scammed or Dealt with an Unethical Lender?
Contact Us or Report it to
Your State authorities.
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