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October 12, 2001, Revised November 17, 2004
What Is a Mortgage Prepayment Penalty?
A prepayment penalty is a provision of your
contract with the lender that states that in the event you pay off the loan
entirely, you will pay a penalty. Penalties are usually expressed as a percent
of the outstanding balance at time of prepayment, or a specified number of
months of interest.
Usually, prepayment penalties decline or
disappear with the passage of time. Seldom do they apply after the fifth year.
Partial prepayments of up to 20% of the balance usually are allowed in any one
year without a penalty. A penalty that applies to a home sale as well as a
refinancing, is a "hard" penalty; if it applies only to a refinancing, it is a
"soft" penalty.
Questions about prepayment penalties come
from several types of borrowers, as illustrated by the letters below.
A Prepayment Penalty May Lower the
Interest Rate on a Prime Loan
"We are committing ourselves up
to the limit of our capacity to buy the house we want. Our broker said we could
reduce the rate from 7% to 6.75% if we accepted a prepayment penalty. This would
reduce our payment by $35 a month, which would help a lot. Should we?"
Probably. The rate quotes indicate you are a
prime borrower -- meaning your credit is good and/or you are making a very large
down payment. Prime borrowers can
usually get a better interest rate if they accept a prepayment penalty.
Lenders, and the investors who buy loans
from lenders in the secondary market, are willing to accept a lower rate in
exchange for a prepayment penalty. The benefit of a prepayment penalty to them
is that it discourages refinancing if interest rates decline in the future.
Most prime borrowers avoid prepayment
penalties, either because they can or because they are never offered the option.
Loan officers usually press to close as soon as possible, and offering options
slows down the process. The upshot is that many prime borrowers who would elect
a prepayment option if they understood it, never get the chance.
You may be a good candidate because you
attach a high value to the lower rate. The question you must consider is what
you are giving up? How large is the penalty? How many years must elapse before
it goes away? And does it apply only to refinancing -- you don�t want to be
subject to penalty if you sell your house. A 2-3% penalty during the first 3-5
years, payable only on a refinancing, is a reasonable price to pay for a 1/4%
reduction in rate.
A Prepayment Penalty May Be Required on a
Sub-Prime Loan
"Because
I have very bad credit, I agreed to pay 11% for a 30-year mortgage. Friends have
warned me to avoid a prepayment penalty, but when I ask the loan officer about
this, he says that the lender absolutely requires it. Do I have any options?"
Probably not. Because of your bad credit, you
are a sub-prime borrower. Lenders generally demand prepayment penalties
on sub-prime loans because the risk of refinancing is higher than on prime
loans. Sub-prime borrowers profit from refinancing if their credit rating
improves, even when the general level of mortgage rates does not change. Prime
borrowers can profit from refinancing only if market interest rates decline.
If you make all your payments on time for the
next two years, and assuming no change in the general market, you might be able
to refinance your 11% loan at 7-8%. But your current lender wants to keep your
11% loan for more than 2 years. Because of high origination costs and high
default costs, sub-prime lending is not profitable if the good loans walk out
the door after only two years.
But that doesn�t mean you have no negotiating
power. While you may not be able to negotiate away the penalty entirely, you
will probably be able to negotiate the specifics. Tell the loan officer: "No
longer than 5 years; no higher than 3%; partial prepayments up to 20% of the
balance allowed in any year without penalty; no penalty on sale of the
property." Be forceful but sweet, keeping in mind that the lender wants your
loan to close.
Prepayment Penalties Are Rarely
Waived
"I�m one of those dupes who never read the
note. I now find myself stuck with a 12% mortgage and a 5% prepayment penalty,
which I can�t afford to pay. Is there any way to get out of it?"
The only way to get out of a contractual
obligation is to induce the other party to the contract to let you out.
But lenders rarely have a reason to waive a prepayment penalty. Considering that
you are terminating a relationship with them to start anew with another lender,
why would they? The lender will
surely say "no" if you ask.
You might have a chance if
the request comes from a more formidable source.
Some sub-prime borrowers have found a community group willing to intercede on
their behalf. If you convince the community group that the original terms were
unreasonably onerous, they just might persuade the lender to rewrite the note.
Contract Chicanery Often Involves
Prepayment Penalties
The letter above was from a borrower who had
been victimized by contract chicanery: the practice of surreptitiously slipping
a provision disadvantageous
to the borrowers into the note.
(Ordinarily, the borrower does not see the note until closing, and probably does
not read it then. )Judging
from my mail, prepayment penalties are the most common objective of contract
chicanery. It can easily be prevented, see
How to Shop For a Mortgage and
Disclosure Rules on Mortgage Prepayment Penalties.
Don't Gift a Prepayment Penalty
to the Lender
�My lender
has requested an addendum to my note that he calls a soft prepayment penalty.
Basically it states that if I prepay more than 20% of the loan within 5years I
will need to pay a penalty equal to six months' interest. If the property is
sold I can have this penalty waived. It is unlikely that I will want to
refinance my 6% fixed-rate loan, so why would the lender request such a clause?
Should I accept it?�
No. This lender evidently priced your loan without a penalty clause, and now
wants to insert it without any quid pro quo. Don�t let him.
When the lender sells your loan in the secondary market, it might be worth 1%
more with the prepayment penalty clause than without. That would, roughly,
double his profit on the deal. But a prepayment penalty should carry a benefit
to you � perhaps a 1/8% reduction in the interest rate.
Your current intentions regarding refinance in the future are wholly
irrelevant. If rates drop from 6% to 4%, you will probably refinance. Investors
in the secondary market understand that, even if you don�t. It is why they are
willing to pay a premium price for a penalty clause that discourages
refinancing.
Assuming you negotiate a penalty with the lender, make sure a provision to
waive the penalty if the house is sold is incorporated in the note. The lender
who ends up owning your loan won�t know anything about any oral promises.
Copyright Jack Guttentag 2004
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