Mortgage Pre-Payment Hell

In my opinion, pre-payment penalties have never been in the consumers’ best interest. Lenders take a different view.  To them, pre-payment penalties are an important source of revenue.  We’re talking hundreds of millions of dollars here, perhaps more.  I cannot conceive of the revenue from such penalties ever being termed “earned income,” which is why lenders are not exactly eager to talk about how much they are making from them.

Countrywide Financial, one of the nation’s largest lenders, has stated that 30% of those who were refinancing ARMs had to pay a pre-payment penalty to get out of their loans.  In my view, 30% of their portfolio is A LOT of loans or, more to the point, a lot of borrowers who got hosed. This is worth discussing in further detail with the hope that, by being forewarned, you will not be tricked into taking out a loan that has a prepayment penalty attached to it -- perhaps one that’s not even disclosed to you.

In my home state of California, there are statutory limitations on penalties that can be put on residential mortgages.  First, they can only apply for five years, although many are written for shorter periods, typically three years. Second, the maximum amount that can be collected is 80% of six month’s interest. The 80% is there because borrowers have a legal right to pre-pay up to 20% in each year without penalty. Let’s calculate how much that might be.

Let’s assume that a borrower signs up for a $400,000 loan, a typical number in a state with high property values. I’m going to assume that anyone with excellent credit gets a loan at a low enough rate that he or she would not be refinancing now.  Let’s assume that the interest rate is 7.5%, typical for the underlying rate on an Option ARM issued in the past few years.  The penalty in this case would be $400,000 x .075 x .5 x 80% = $12,000. Argggghhhh!

You can see that when you add that to the normal cost of a refinance, it’s pretty expensive. Of course, it’s possible that the underlying rate could head higher and, assuming that the borrower could now afford a fully-amortized fixed rate loan, it probably still would make sense to refinance anyway.

There is an insidious thing about pre-penalties. Because they are so lucrative for lenders, they often pay incentives to loan officers to tack them onto the loans. Obviously, 30% of Countrywide’s borrowers didn’t ASK for the penalty. They didn’t say, “This loan has all the features I want except a pre-payment penalty.  Can I get one of those too?”

It is not at all uncommon for wholesale lenders to attach prepayment penalties to every loan they offer. The borrower actually has to pay to get them taken off. If you are dealing with an honest loan officer, he would say, “You can have this loan with or without a pre-payment penalty. Here’s the difference in price.”

If you weren’t told, but you found out about it, you might say, “How much would it cost me to get out of this pre-payment penalty?”  The answer on many loans is from a quarter to a half of a point. In the example above, getting out of one on a $400,000 loan would cost between $1,000-$2,000.  Now, if you as a borrower had a choice of paying $2,000 to avoid a $12,000 payment, what would you choose?

Bottom line: lenders pay loan officers very well to stick penalties onto loans, sometimes without telling the borrowers.  Here’s information from a typical rate sheet for one lender’s Option ARM program.

One choice, one that I do for clients, involves no pre-payment penalty.  The borrower pays a start rate of only 1% but the underlying note rate is 2.75% over the 1 year MTA (Moving Treasury Average) Index, currently 4.933%.  Thus the note accrues interest at a real rate of 7.683%.

However, if I were to sell the exact same loan with a 1-year pre-payment penalty, my compensation as the broker would go up by one-half point. Let’s say I make my typical 1 point on a $400,000 loan, $4,000. If I add the pre-payment penalty, the lender pays me an additional $2,000, a 50% increase.  And it’s not like I had to work harder to get that added income.

It gets better.  If I closed this exact same loan with a 3-year pre-payment penalty, my compensation would go up even more.  I could actually make $13,000 on this transaction instead of $4,000.  If I sold it with a 3.75% margin, increasing the borrower’s interest cost by $4,000 each year, I could make $19,000. 

Note that if the client had to get out of it before three years, he’d have to pay a $12,000 pre-payment penalty.

Does this happen in real life?  All the time! I am currently refinancing a home where the client has an 8.25% loan and a pre-payment penalty of $22,000.  His broker, a member of his extended family, made a whopping $19,250 in commission on this one deal! That’s more than some loan officers make in two or three months. So much for trusting the family!

Notice of a pre-payment penalty should rightly appear several places:

1. The initial Truth-In-Lending (TIL) statement
2. The Final Truth-in-Lending statement that accompanies documents
3. In the Promissory Note in a paragraph near the end
4. Sometimes there will be a special “rider” that explains the pre-payment penalty

All of these require your signature, so you should have ample opportunity to be warned. However, it’s not uncommon for it not to be included on the initial TIL, but slipped in on the final one, in the hope that you won’t notice. I heard of one instance where it was obvious that someone other than the borrower signed that rider!

Be careful. Be very careful!

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