Why We No Longer See Prepayment Penalties

PREPAYMENT PENALTIES EXPLAINED

Prior to the mortgage meltdown of 2008, mortgage prepayment penalties were common.

These were penalties that borrowers had to pay if they paid off all or a portion of their mortgages.

Lenders imposed the penalties b/c they wanted to be able to recoup the cost of the loan before the borrower refinanced or paid it off.

For example, a lender providing a $500,000 loan could easily incur $15,000 to $20,000 of costs to fund a loan by paying the loan officer a commission of 1.5% (of the loan amount) and the borrower a 1.5% credit for closing costs.

A prepayment penalty allowed the lender to collect enough interest to recoup those costs before the borrower refinanced.

A typical prepayment penalty was six months of interest against 80% of the remaining principal. In the case of the $500,000 loan above and an interest rate of 8% (often seen at that time), the prepayment penalty would be around $16,000.

This is why prepayment penalties had to be regulated.

SLIMY MORTGAGE BROKERS & SUBPRIME LOANS

Prior to 2008, subprime and “Alt A” loans comprised a major portion of all mortgages. Some of these loans were very competitive, particularly when honest loan officers originated them.

But – slime-balls prevailed. Most of the subprime and Alt A loans were adjustable rate loans with fixed and very low “start rates” (often below 2%) that remained fixed for six months to 2 years.

Even though the start rates were fixed, the loans had adjustable rates tied to an index (like LIBOR) with a “margin” on top of the index. Hence, if LIBOR was 5%, and the margin was 3.5%, the borrower’s adjustable rate would be 8.5%.

Many slimy brokers sold the “start rate” as if it was the actual interest rate without fully explaining how the adjustable rate portion worked.

WORSE – if they saddled the borrower with a higher margin, the broker would get a higher commission.

Many mortgage brokers would sell Negative Amortization ARMs with start rates of 1.95%, sky-high margins, 3% commissions to the broker himself, and 5-year prepayment penalties.

And borrowers often had no idea what they were getting, particularly if English was a second language.

We used to frequently have borrowers come to us with sky-high rates and huge prepayment penalties, and then face the choice of either paying a $20,000 penalty or keeping the high rate (all b/c a slimy broker wanted to make an extra $7,500 of commission).

It was often heartbreaking to see this.

I rarely come out in favor of more regulation, but in this case it was necessary for obvious reasons.

Dodd-Frank, the CFPB, and the current legal environment made prepayment penalties much more difficult to impose and/or enforce, and they are virtually non-existent today with “A paper” or “QM” loans.

At JVM, we do not offer a single loan with a prepayment penalty.

Jay Voorhees at (925) 855-4491
Real Estate Broker, CA Department of Real Estate, DRE# 01524255, NMLS# 335646