Prepayment Penalties
The word “penalty” usually drums up less-than-stellar images in one’s mind. So why are loan brokerages and banks so quick to attach penalties to your loan, after having jumped through so many hoops just to procure it? The answer is not clear-cut, but there are a few common reasons you might have to deal with one.
Description
A prepayment penalty, at its core, is an amount of time in which you may not pay off your loan in full without being charged an additional fee, which is usually calculated from your original loan amount. A “Prepayment Addendum” to your loan might require you to pay six months’ advance interest on the amount you prepaid over 20% of your loan in any 12-month period. What does that mean if you refinanced your loan completely? You would be responsible for paying interest due on up to 80% of your loan. On a $300,000 loan at 6.00%, that’s $14,400.
There are two common types of prepayment penalties: soft and hard. The difference between the two types is what events will trigger a prepayment fee.
- Soft prepayment penalty: When a prepayment penalty is “soft,” you will incur a charge if you refinance your mortgage before the prepayment term has expired. However, you may sell your house without incurring a charge.
- Hard prepayment penalty: With a “hard” prepayment penalty, both refinancing your mortgage and selling your house will subject you to a prepayment penalty.
Why does my loan have a prepayment penalty?
There are a number of reasons why a loan agent might add a prepayment penalty to your loan. Some are dubious, others are for legitimate reasons. I’ll try to describe the more legitimate reasons first, and then go over the others.
- Sometimes a borrower does not qualify for a particular program (the “program” might be a “30-year fixed” or a “5-year adjustable” mortgage). His credit score may be bruised or he may not make enough money to make the bank comfortable about the loan. Banks can attach prepayment penalties to loans to lower their risk in the loans. Since banks see borrowers as potential risk, not people (an unfortunate truth), anything to lower risk sits better with them. When a bank knows it can still recoup some of its investment if a borrower decides to go with a competitor six months after getting his mortgage–which happens all the time–it will most likely be more willing to lend to that borrower.
- Banks will usually attach larger “rebates” to loans with prepayment penalties attached to them. While this can be a potentially bad thing (as described in the next item), it can also be incentive to give a borrower a lower interest rate. For example, a loan with a 6.00% interest rate and no prepayment penalty might have a 0.5% rebate attached to it. On a $300,000 loan, that means the loan agent will receive $1,500 from the bank for closing the loan. If the borrower decides she’d like to have a 5.75% interest rate but the loan agent sees that will carry only a 0.125% rebate ($375 on a $300,000 loan), he might negotiate with the borrower to put a 1-year prepayment penalty on the loan, which could bump the rebate back to 0.5%. Since borrowers are less likely to refinance loans with lower-than-market interest rates, staying in her mortgage for one year to receive the lower monthly payment would probably be a good trade-off.
- Since adding prepayment penalties to loans usually increases the amount of money the loan agent receives from the bank (again, the “rebate”), some less-than-reputable loan agents might use prepayment penalties to arbitrarily increase their profits while putting borrowers in poor positions with their loans. Six-month and 1-year prepayment penalties are common, but 3- and 5-year prepayment penalties are also options offered by some banks, with hefty rebate increases attached. If a loan agent can convince his borrower to agree on a longer prepayment term, it might mean the difference between receiving $1,500 and $3,500 on the loan. Unfortunately, most of the time borrowers are not well informed of the addendums to their loans, and when it comes time to refinance their mortgages or sell their houses, problems can arise.
How can I protect myself?
There are a few steps you can take when applying for a loan to make sure you stay fully informed throughout the process:
- Ask your loan agent if there will be a prepayment penalty attached to the loan. You can ask for it in writing as well, but use your intuition: if he’s skirting the issue or is throwing around terms you are unfamiliar with, you might be better off getting a second opinion.
- When it comes time to sign your loan papers, read them carefully. Some escrow companies will try to hurry you up, but do not sign anything you are not fully comfortable with. When you are looking at your loan, pay specific attention to your “Note.” It will show you the amount of money you are being lent, the interest rate you will pay on the loan, and it will have addendums specifying anything non-standard; prepayment penalties fall into this category. A “Prepayment Addendum” or some variation thereof should be attached to your Note if one exists. This page must be signed, so pay attention to the name of the documents you are signing, not the descriptions being read to you (by someone who may be trying to hurry you along).
Your loan is a contract. If you learn two years into your loan while trying to sell your house that you have a 3-year hard prepayment penalty on it, it is difficult to prove due diligence was not performed by the loan agent, since you signed your loan documents in full. Read your loan documents, ask questions of your loan agent, get any unclear items in writing before signing your loan documents, and don’t be afraid to get a second (or third) opinion.