Under the Mortgage Microscope: Prepayment penalties understood.

By
Mortgage and Lending with Pacific Funding

Despite consumers dislike for prepayment penalties lenders often make them a requirement of the loan.  Nobody wants one; nobody likes them.  So why can't we just get rid of them altogether?  My rule of thumb is to generally avoid prepayment penalties when possible, but is there ever a time when it's advisable to accept a prepayment penalty? 

To answer this, we need to look at the big picture so that we can better understand the role of prepayment penalties in a loan.  Sure, prepayment penalties exist to protect the lenders profit margin on a loan, but a closer look reveals that the driving force behind prepayment penalties is the need to lend in a marketplace that would otherwise not exist.

Say for example a lender has $25M to lend.  They can choose to lend that money to borrowers with strong credit scores and make a profit margin of 2-3%, or they can choose to lend this money to higher risk - low credit score borrowers and make higher profit margins of say 4-5%. 

Herein lays the reason for the prepayment penalty.  Without a mechanism to tie a borrower to a loan for some pre-determined period of time, the lender bears the risk of losing the intended profit margin which is the driving force behind their willingness to provide loans to individuals with less than perfect credit histories.   In other words, why lend money to higher risk borrowers if there's no additional gain. 

It's for this reason that sub-prime loans contain a pre-payment penalty.  However the penalties are not exclusive to the sub-prime borrower.  Often you will find A paper borrowers that have a penalty.  In these cases it can be for other reasons.  Remember, just because a borrower has "A" grade credit it doesn't mean they qualify for an "A" grade loan, many other factors are in play.  The type of income documentation provided, and the loan to value ratio, are some of the reasons why an "A" borrower may have a loan that requires to have a prepayment penalty.

So Should I accept a prepayment penalty?

No.  Avoid prepayment penalties any time that you can.  Remember, the penalties are there for the lenders sake not yours.  Sometimes you will get a lower interest rate for accepting a penalty, but this rate reduction needs to be weighed heavily against your ability to get out of this loan if necessary.  Most people can reasonably forecast their lives for the next year and a 1 year prepayment penalty is pretty safe bet.  However, anything longer than a year has too much uncertainty.  Take into consideration that a family hardship, the loss of income, or any unexpected reason requiring you to sell or refinance the property will likely cost you thousands of dollars if you trigger a prepayment clause.  Therefore the savings associated with a rate reduction will be eaten away by the penalty should you trigger it.

If your credit score and borrowing situation is such that you can't get around a prepayment penalty, then you have no choice but to accept it. However, before you accept a penalty, you need to be certain that you understand it and can live with the loan as it is for the duration of the penalty period.  

Generally, there are 2 types of prepayment penalties, Hard and Soft and they can range from 1-5 years in length.   

A hard penalty means that if you refinance or sell the property, the penalty will be invoked and you will have to pay the lender..

A soft prepayment penalty means that the borrower can sell the property without penalty however if they try to refinance the property, the penalty will apply.

So needless to say prepayment penalties will always exist as long as there is a market for lending to anyone other than the perfect borrower.   

 

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Tags:
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Anonymous
John Baker

Martin

My Credit score was below 600.  I didn't think I could ever qualify for a loan. Sure its not the best interest rate and I'm stuck with 3 year prepay penalty, but at least I'm not renting and in 3 years my credit should be better. 

I'll take a Prepay penalty any day over paying a landlord rent.  Sure my hands are tied to this house, but who cares the property is mine and I knew that going in.

Thanks for the info.
John,  Henderson NV

Mar 07, 2007 07:06 PM #1
Anonymous
Melissa Lohrman

Martin

My husband and I have been arguing over our prepayment penalty for the last 2 nights.  We're getting a loan and he wants to buy out of the prepay penalty at a cost $5000.  I think thats wasted money.  We don't plan to move out of our home anytime soon and I think paying $5000 upfront is alot of money. 

Why not take the prepay penalty and just pay the penalty if we decide to sell.  Don't you think thats a smarter way of doing it?  Would love to hear your advise.

Melissa, Stockton, CA

Mar 07, 2007 07:11 PM #2
Rainer
36,951
Martin Rodriguez
Pacific Funding - Valencia, CA
Senior Loan Consultant

Hi Melissa

Unfortunately, I don't have enough information about your circumstances to give you good advice in this forum.   You can certainly feel free to call me and I will happily review your loan and give you an in depth consultation. 

You need to uderstand why the lender is imposing the penalty and then weigh that against the likelihood that you will sell or refi before the period expires.  Like I said in my post, its always best to avoid the penalty if you can, but if it getting out of the penalty requires a hefty upfront payment only you can decide how important that is to you.

Hope that helps..  Thats about as much as I can tell you without having all the details.

Thanks for visiting my blog.
Martin

Mar 07, 2007 07:20 PM #3
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Martin Rodriguez

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