A young couple was sitting in my office crying.
It was around 2005, they were on a very tight budget, their rate had just adjusted to almost 10%, they had to refinance in a hurry for a variety of serious personal reasons, and they had just discovered that their loan officer had saddled them with a 5-year prepayment penalty of $18,000 (for a relatively small loan).
The couple also did not speak English well and the loan officer took complete advantage of them – and this is how.
Many loans prior to 2008 had fixed and relatively low “start rates” for one to two years, but “margins” that could vary tremendously.
The “margins” were used to establish a person’s interest rate above a certain “index.” For example, if a person’s loan was tied to the Monthly Treasury Average (MTA) index at say 5% (at the time), and his margin was 2.5%, his interest rate would adjust to 7.5% after the “start rate” period ended.
The problem was that loan officers could get more commission by selling higher margins (even though the “start rates” did not change).
A 2.5% margin might yield a commission equal to 1% of the loan amount; a 4% margin might yield 2% of the loan amount; and a 5%+ margin might yield 3%, and so on.
The higher the commission though, the longer the prepayment penalty, e.g. a 1% commission usually equated to a one-year prepayment penalty; a 2%+ commission equated to 3 years; and a 3%+ commission equated to 5 years.
Unscrupulous loan officers would only focus on the fixed start rate when pitching loan options and never explain the different margin options, and thus subject people to very high rates and massive prepayment penalties in order to earn extra commission.
PREPAYMENT PENALTIES – WILL THEY RETURN?
This happened all the time, and THIS is why Dodd-Frank and other regulators rightfully cracked down on prepayment penalties.
As an aside, during my loan officer days, I never earned more than a 1% commission; I avoided prepayment penalties like the plague; and I helped the couple above by crediting my commission towards their prepayment penalty – so desperate was their situation.
In any case, I was asked recently if I thought prepayment penalties would return, and my answer was no.
Here is a short article from Nolo, explaining how prepayment penalties were restricted and when they are allowed.
They are still allowed but the many restrictions make them less practical and disclosure requirements and stigmas make them much harder to sell.
In addition, lenders themselves want to avoid the stigma and regulatory scrutiny that prepayment penalties invite.
Most importantly though – Fannie, Freddie, and HUD (FHA & VA) prohibit prepayment penalties (the main reason we will not see them return).
Many lenders “brag” that none of their loans have prepayment penalties nowadays, but that is somewhat misleading because I am unaware of any lender that does.
There are different kinds of prepayment penalties too, including Hard and Soft penalties.
A Hard Prepayment Penalty is a penalty that borrowers pay no matter what if their mortgage is paid off within a certain period of time.
A Soft Prepayment Penalty is incurred only if borrowers pay off their mortgage with cash or a refi, but it is not imposed if borrowers sell their home.
Most prepayment penalties back in the day were equal to six months of interest against 80% of the remaining principal.
EARLY PAY OFF PENALTIES
Prepayment penalties should not be confused with the Early Payoff Penalties (EPOs) that ONLY Lenders are subject to.
As I remind readers often, lenders agree to pay a penalty to every investor to whom they sell loans if a loan pays off within six months of the date of sale (most loans are sold to investors within a few weeks of funding).
These penalties can easily approach $20,000 and are very expensive for all lenders.
We desperately try to keep our borrowers from refinancing for six months with various education programs and reminders, and we never pay off loans that were funded by other mortgage banks within the last six months.
EPOs represent a major expense for the mortgage industry and rates are no doubt slightly higher to account for this expense.
Hence, if lenders could actually include a six-month prepayment penalty clause in every borrower’s note (to prevent EPOs), rates would be lower.
But, I just don’t see that happening for the reasons set out above.
Jay Voorhees
Founder/Broker | JVM Lending
(855) 855-4491 | DRE# 1197176, NMLS# 310167
