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Over the years lenders have developed numerous products and loan modifications which provide the opportunity for you, the borrower, to get the lowest rate possible in exchange for some type of offset such as security (as in short-term adjustable rate mortgages) freedom (2-5 year pre-payment penalties) or deferred expense (negative amortization loans, short-term teaser rate loans and interest only periods). These trade-offs that you make for that lower rate have varying levels of impact on your overall financial well being and your flexibility as a homeowner to respond to changing market conditions as well as changes in your life. In this series we are going to look at the mostly cons of choosing some of these loan modifications when deciding on new financing; as well as look at some real costs behind these choices to help you better decide which financing option is right for you when shopping for a home loan.
To kick off this consumer help series we are going to look at pre-payment penalties.
What is a Pre-Payment Penalty?
A pre-payment penalty is just what the name implies: it is a monetary penalty due in the event that your loan is paid in part (over a lender-defined percentage of the outstanding balance) or in full before the expiration of a particular time frame.
What is the Penalty?
The penalty varies by lender and by loan product. To determine the specific cost of your pre-payment penalty you’ll need to refer to your loan documents you signed at the close of your loan. However, a good rule of thumb for calculating the pre-payment penalty is 6 months of interest payments.
What does this look like? Well consider the following loan:
- 30-year fixed loan
- $250,000 loan amount
- 6.75% interest rate (fully amortized)
- 2-year prepayment penalty
The monthly payment on that loan (principal & interest) is going to be $1621.50, with interest being approximately $1405 (depending on how many previous payments were made before paying the loan off).
If we choose to pay off this loan before the 24th month this pre-payment penalty will be approximately: $8,430 (nothing to sneeze at).
As I said before, pre-payment penalties come in all flavors, so check your loan documents for your specific penalty; or contact your loan servicer’s customer service department and they can tell you directly.
When is the Pre-Payment Penalty Enforced?
The pre-payment penalty is enforced upon the event of either a large portion of the loan being paid down (for example more than 20% of the principal loan balance in one month) or if the entire loan is scheduled to be paid off (via a refinance or home sale). This money is due immediately, but the funds can be financed in to a new home loan at the time of closing (provided there is enough equity in the home to accommodate that charge).
Are All Pre-Payment Penalties the Same?
No. Not all pre-payment penalties are alike. In addition to the above-mentioned variances these penalties typically come in one of two major forms:
- Soft pre-payment penalties
- Hard pre-payment penalties
Soft Pre-Payment Penalties: These are pre-payment penalties that are only enforced when an existing loan is paid down substantially in a short time period, or is refinanced prior to the expiration of the penalty. If either of these two events occur the soft penalty is due and payable immediately. However, if you sell the property that the loan is tied to then the pre-payment penalty is NOT due, even though the loan was paid off prior to the expiration of the penalty.
Hard Pre-Payment Penalties: These are pre-payment penalties that are enforced when an existing loan is paid down substantially in a short time period or is paid in full – regardless of manner – prior to the expiration of the penalty. This applies even if you sell your home within the limits of the pre-payment penalty time frame. It is due and payable immediately.
What are the Typical Lengths of Pre-Payment Penalties?
Most pre-payment penalties are based on the fixed period of the loan, and are often limited by state law in terms of their duration and maximum charge. Common pre-payment penalty terms are 2-year, 3-year, and 5-year.
For example a 2-year fixed adjustable rate mortgage could carry a 2-year pre-payment penalty; while a 5-year ARM may carry a 5-year pre-pay. Pre-pays can also exist on fixed loan products to lower the rates of 30-year and 40-year fixed loans. Some states do not allow a pre-payment penalty. While your lender should know this, you may have been placed in a pre-payment penalty in a state where one is not enforceable; check your state law to determine whether a pre-payment is legal in your state.
Who Would Take a Pre-Payment Penalty?
Most of the pre-payment penalties that were issued (and continue to be issued) are on loans that are usually subprime short term adjustable rate mortgages. While they typically can be placed on most loans, they are often found on subprime mortgages. Subprime home loans are for people with less-than-perfect credit who need home financing.
Many subprime borrowers were faced with a difficult choice. Choose a loan with a pre-pay of some duration and receive an attractive interest rate and mortgage payment that they could afford or choose a much more costly interest rate and monthly payment for the flexibility of no pre-payment penalty. Many chose the former, betting that they wouldn’t need to refinance their new home loan before their current pre-payment penalty expired.
This is the gamble with the pre-payment penalty. You are betting that your need for lower monthly payments is more likely to be the most important financial factor in your life for the duration of the pre-pay window than the actual likelihood that you may need to make changes to your home finances to a degree that would trigger the pre-pay to be due and payable.
Many subprime borrowers took that gamble, and ended up being wrong. (More on that later.)
Will My Lender Waive My Pre-Payment Penalty?
A favorite question of borrowers who are still within their pre-payment window and looking to refinance their home loan or sell their home. The short answer is no. Lenders build in the pre-payment penalty to off-set the risk of early payments. When they have a guaranteed penalty the duration of the loans is longer (or they are compensated via the penalty) which means the loans are more profitable through the collection of interest over longer periods of time. This profit allows them to offer lower rates; but the model doesn’t work if the interest rates are lower and the loans are paid off faster – the profit vanishes.
Because of these economic realities, most lenders will not waive your pre-payment penalty. There are some rare exceptions however, primarily in the case that you return to the current lender to refinance in to another one of their loans. In those instances they may be willing to waive the penalty since they are retaining you as a customer and are making profit on the fees associated with the refinance transaction.
Pre-payment penalties may also be waived by loss-mitigation departments of lenders in short-sale transactions or loan modification agreements. In these situations they may choose to waive the pre-payment penalty to help avoid foreclosure. These waivers are granted on an exception basis following a thorough case review.
What if I Have a Pre-Payment Penalty that I Wasn’t Aware of?
Many people have complained about being put in to a loan with a pre-payment penalty with out their knowledge. While you sign several pieces of paper outlining the penalty and charges at loan signing; it is possible that with the hurricane of paper work that you signed at the loan closing that you missed those important documents. If that is the case with your loan there are a couple of options that you may have.
1. If you live in a state where pre-payments are not allowed the penalty on your home cannot be enforced by the lender. Double check your state law as it refers to the penalty.
2. Some states have very specific requirements and time limits for pre-payment penalties. If you have a 5-year pre-payment penalty but your state maximum limit is 3-years the lender has to let you out of the last two years; and the entire penalty may be found void if it does not conform with state law.
3. One helpful reader who works in loan due diligence emailed me to let me know that there is often a miscalculation which makes the prep-payment charge outside of the maximum allowable charge per state law. The math is a bit funky, but email me directly if you feel you were put in a pre-payment penalty unwittingly and want to see if the charge is legal and in compliance with state law. It’s worth looking at your loan documents to see if the pre-payment is enforceable, or outside of state law.
Why Would I Pay My Pre-Payment Penalty?
Many borrowers find that their economic situation is not as stable as they originally envisaged when they signed the loan documents for their home loan. These changes put pressure on them to tap their main source of equity (their home) and they choose to forfeit the penalty and hope that appreciating home prices in their area replenish the equity lost to the penalty charge. In previous years the penalties were shrugged off often as a cost of getting cash out of the home on a repeated basis; the pain of which was reduced by the ever-appreciating property values.
In our existing environment however, pre-payment penalties can be like a blanket on a fire, snuffing out any available equity and wiggle room to allow a borrower to refinance out of their current mortgage and in to a new one. As home prices decline, the penalties make up a larger percentage of the remaining equity in the house; which will continue to limit refinance opportunities for people still in the pre-payment stage of their loan.
Should Anyone Choose a Pre-Payment Penalty?
Pre-payment penalties are attractive to borrowers because they offer significant discounts on the interest rates and monthly payments available to them when compared to loans with out pre-pays (especially for subprime borrowers). In general, I advocate avoiding a pre-payment penalty because it limits your options for future financing needs. Most people’s financial position is not as stable as it looks, and changes in employment, desires to change residences, or other economic drivers can lead to a sudden need to pay off a loan. This is true even if those same people originally foresaw no possibility of a change of this magnitude occurring during the pre-pay time period.
Because of this I recommend taking a slightly higher interest rate and monthly payment in exchange for the freedom and flexibility of not having a penalty. I look at the higher payment each month as a small insurance premium against the need to make a sudden, unexpected (and drastic) move in my home financing situation.
There are some limited examples of where a pre-payment penalty may make some marginal sense for particular scenarios. Those scenarios are ones where extreme stability is guaranteed for a fixed period of time. For example a newly-retired couple may consider a 2-year pre-payment penalty on a 30-year loan to enjoy a lower interest rate over the life of the last loan they’ll ever have. The savings over 30-years can be substantial with even a .5% difference in interest rate as a result of choosing the penalty.
Let’s compare that same $250,000 loan on a 30-year fixed.
- At 6.75% with no prepayment penalty you end up paying a total of $1621.50 (P&I) each month.
- With a 2-year pre-pay and 6.25% rate the monthly mortgage payment is $1539.29 (P&I).
That’s a monthly savings of $82.21 at the lower rate. And that will translate in to a massive savings on interest costs. In fact, if you took the lower rate and re-applied the $82.21 back to your mortgage payment, you’d pay off the second mortgage 4 years faster than the 6.75% rated mortgage.
In similar situations where stability is highly likely pre-payment penalties may make some financial sense.This of course has to be hedged against the unknown. A newly retired couple could face unexpected medical expenses that require them to tap their home equity. They would then be forced to pay that penalty. And in each situation where it may make some sense to consider a penalty; it is the uncertainty surrounding everyday life that makes them a gamble.
So the question is “Do you feel lucky?” and if so are you willing to risk the potential large loss of (in the above example) $8,400 of (now) precious equity should you find yourself in a bind and need to access it; or are you going to buy the monthly insurance of the higher monthly payment for no pre-pay and greater flexibility in your home financing needs?
In the end the choice is yours, but be sure to ask yourself “Do you feel lucky?” before signing on to any prepayment penalty.
Well do ya’ Punk?
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