"Prepayment Penalties: Pros and Cons" “Prepayment penalties” have become one of those phrases that borrowers automatically assume is negative when dealing with their mortgage lender. Prepayment penalties are not usually negative. They are simply misunderstood. The clients I speak with on a daily basis nearly all say the same thing, “my friend says I should ask for a mortgage with no prepayment penalty.” Unless you are looking to flip the property in under 12 months, which a lot of people did in 2004, you should not be afraid of a prepayment penalty. In fact, they are often a good thing and can reduce your monthly payment substantially. “What is a Mortgage Prepayment Penalty?” A prepayment penalty is a contractual obligation that states that in the event you pay off the loan entirely before a certain period of time you will pay a penalty. Generally, you will be offered a lower interest rate or lower fees on your mortgage in exchange. Penalties are usually a percentage of the outstanding balance at time of prepayment, or a specified number of months of interest. Most prepayment penalties I deal with are around six month’s interest. Let’s say your mortgage payment is $1200/mo. Of this, let’s say that $1000 is interest. Now let’s assume you have a two-year prepayment penalty. This means if you pay off your mortgage, in full, by selling the home or refinancing the mortgage before two years have gone by you will pay a prepayment penalty to the bank of six months interest or $6000 as a penalty for early payoff. Sounds like a lot to pay. But as you will read below it may be of value. Prepayment penalty contracts will usually include a provision to allow you up to pay up to 20% of the mortgage in any one year without a penalty. For example, if your mortgage is $300,000, you can pay up to $60,000 a year without the penalty taking effect. There are two different kinds of prepayment penalties. A “hard” prepayment penalty means that you cannot sell or refinance the home within the prepayment penalty period. A “soft” prepayment penalty only applies to a refinancing. You can sell it at anytime without penalty. You can’t refinance it without penalty. "What are the advantages of a prepayment penalty mortgage?" Possible cost savings of reduced fees or closing costs and possibly lower interest rates. "What are the disadvantages of a prepayment penalty mortgage?" If you pay off your mortgage in full before it is due or if you choose to refinance your loan, you may owe a substantial prepayment penalty. “Why should I accept a prepayment penalty?” Prime borrowers (good credit) will usually get a better interest rate if they accept a prepayment penalty and they make get discounted fees. Failure to accept it may result in higher rates and fees. Think about it. You are the bank. Your client has asked you for a $300,000 loan. Your profits come from this client making years of interest payments on the loan. The fewer years your client pays, the less profit to you. Thus, investors who buy loans from lenders in the secondary market are willing to accept a lower rate in exchange for a prepayment penalty. They want the security of being able to count on your payments. The benefit of a prepayment penalty to them is that it discourages you from refinancing if interest rates decline in the future. If you borrow money from them at 6.000% and the rate drops to 5.000% at a later date but you stop yourself from refinancing due to a prepayment penalty, it means even greater profits for the bank. However, you may save between .250% and .500% by accepting a prepayment penalty. On a $300,000 loan, this can be between $50-100 per month. $600-$1200 yearly. Its not a bad deal for simply agreeing not to refinance for a while, especially when there is no way to predict future interest rates. Even with these great benefits, most prime borrowers avoid prepayment penalties. They do this because of the negative connotation that it got from someone who they trust or because they were simply never offered the option by their loan “expert.” As you are aware, many loan officers barely know their loan programs let alone the benefits of a prepayment penalty so they never give the borrower the option. The borrower's friend or neighbor told them not to accept a prepayment penalty, so they simply don't want it. This is very costly to your clients. Many more prime borrowers would elect a prepayment penalty option if they understood it. They just never get the chance. “How long a penalty should I accept?” Choosing a prepayment penalty mortgage is a personal decision that depends on both your current financial situation and how long you think you'll keep your mortgage before refinancing or making a very large payment against it. The question you have to ask yourself is just like the question you ask when considering an adjustable rate mortgage. How long will I be in this house?? How long will I have this loan? The other thing to consider is how good you believe your interest rate compared to where it will go. You don’t want to be boxed into a prepayment penalty, see rates go way down, and then not be able to react and refinance. I suggest you check out the rates for your loan with no pp penalty, with a one year pp penalty, and then with a two-year pp penalty. You really don’t want to be penalized for selling your home so try and get the penalty to be a “soft” prepayment penalty. If you are positive that you will not be selling this house for a while, consider the “hard” penalties as well. A penalty of six months interest, payable only on refinancing within two years, is a very reasonable price to pay for a .25%-.50% reduction in rate. You can save $1,000's in the short term and $10,000's over 30 years. When I purchased my own home, I accepted a hard one-year prepayment penalty. Rates went down and I refinanced it after one year. I accepted another one-year hard prepayment penalty. It pushed my rate further down in both cases. “Do I have an option on a prepayment penalty if I am a sub-prime borrower?” Lenders generally demand prepayment penalties on sub-prime loans because the risk of refinancing is higher than on prime loans. They do this because sub-prime borrowers are looking to refinance from the moment they take possession of their new home. A sub-prime borrower controls his own market. Even if interest rates go up, he can still get his rate down by simply improving his credit. Good credit borrowers will only refinance if rates go down. Let’s say that Bill is a sub-prime borrower with bad credit. He gets into a 30 year loan for 10.000%. At the same time, Chris, a good credit borrower, gets 6.000% for the same loan. If rates go to 7.000% in the next year, Chris has absolutely no reason to refinance. Let’s say that over this same period, Bill works on his credit and is now no longer considered a sub-prime borrower. He should be able to refinance at 7.000% or slightly higher. The bank took a lot of risk on "bad-credit" Bill when it originally loaned to him and now "better- credit" Bill wants out. Because of high costs and high default rates associated with sub-prime lending, it is not profitable if the good loans leave after only one to two years. If you are sub-prime, still try and negotiate. Although you will probably have to accept some kind of pp penalty, you will probably be able to negotiate the specifics of the deal. Try and make it no longer than two years and see if they will give you a soft instead of a hard pp penalty. Even with bad credit, you are still the customer and the lender still wants to make a sale. “How do I avoid getting duped?” I cannot tell you how many calls I receive from clients looking to refinance their home who don’t know if they have a prepayment penalty. Then there are the times when they think they didn’t have one only to have it show up in the payoff statement of the mortgage when we are getting ready to close the refinance. I have heard many nightmare stories about unethical mortgage companies and their loan officers slipping prepayment penalties into loans without the borrower knowing. The borrower does not carefully review what they are signing, they had no discussion about it prior, and they end up with a horrible, non-beneficial prepayment penalty. Prepayment penalties can go as high as five years. If you are not paying attention, you could be stuck in your loan, with no way out except a massive penalty, for a very long time. To avoid getting into a situation like this, address prepayment penalties with your loan officer at the very first meeting. If you are OK with one, use it to your advantage to negotiate a better rate. Read your loan docs carefully at signing to make sure they are exactly as agreed BEFORE you sign them. Ask the escrow officer at your signing or your loan officer to go over the prepayment penalty document with you in detail. Don’t accept any verbal promises. If it’s not in writing it does not exist. Don’t sign any addendums after your original loan docs without careful review. Once again, unethical lenders may try and get you to sign a prepayment penalty addendum AFTER the fact. Lenders sometimes make mistakes. We may ask you to sign note corrections and other forms after it seemed like the transaction was complete. You even sign an errors and omissions statement at closing that protects us when this happens. However, all corrections should be related to the deal as you accepted it in your discussions with your lender. If the lender made a mistake about a prepayment penalty that you knew about and had agreed to you should sign this addendum. If you are presented an addendum for a prepayment penalty with terms that you did not previously agree to, tell them to forget it. “I was duped or I didn’t know what I was getting into. How do I get out of it now?” The prepayment penalty is a contractual obligation no different than the rest of your loan docs. The only way out of it is to get the other party to the contract to let you out. This is not very likely. Lenders have no reason to waive a prepayment penalty. You are asking them for permission to end your business relationship with them. In addition, borrowers call banks everyday trying to get out of prepayment penalties that they knowingly agreed to, especially when interest rates fall or they get an unexpected offer on their house that they can't refuse. They make up every excuse they can think of to get rid of it. When you call to cry foul, you will not be the first caller that day crying the same thing. An official at a well-known secondary bank once told me that there was no possible excuse he could think of, short of death, to warrant letting someone out of the penalty. You may have a better chance with an attorney or the company that originated your loan. If you can convince the originating bank that you were “taken” by one of their loan officers and that the terms are far too strict, they may be able to rewrite your prepayment penalty note and take the financial hit from the secondary bank themselves. Please don’t count on this. There is simply no excuse for not having read your loan documents when you signed them. Read before you sign. "What should I ask my lender about the prepayment penalty?" • The terms of the mortgage provision containing the prepayment penalty. • The amount of the penalty you'll be required to pay. • The time period in which the penalty will be charged if you prepay or make a substantial payment. • Other conditions under which the lender may charge you a prepayment penalty. • How much you'll save on your closing costs or fees. • If your interest rate will be lower. • If the fee will be waived if you sell your home during the penalty period. • How the penalty is calculated. • When you can prepay without incurring a penalty. The final word…. The bottom line is this…if you have good credit, you will usually not be required to have a prepayment penalty. But that option may increase your rate from where it could be and may even create additional fees. If you have bad credit, you may be required to have a prepayment penalty to allow the lender to benefit from some of the risk he is taking by loaning you money. Either way, it is important for your clients to make this an open part of the discussion with their lender from day one. It will benefit everyone. Have a great and prosperous month!!! Best regards, Aaron Gordon Senior Mortgage Banker REALTY MORTGAGE/Las Vegas 7830 West Sahara Las Vegas, NV 89117 (702) 869-8790 Direct Line: (702) 283-2333 Toll-Free: (888) 216-0903 Fax: (702) 869-8925 email@example.com MSN Instant Messenger: firstname.lastname@example.org IMPORTANT INFORMATION: THIS NEWSLETTER CURRENTLY GOES OUT TO OVER 10,000 REAL ESTATE AGENTS IN LAS VEGAS, PHOENIX, AND SCOTTSDALE . If you have any topics you would like me to research or discuss in future newsletters, please do not hesitate to email me suggestions. To the readers of this email whom I also count as clients... "Thank you so much for your continued business!! 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