Another day, another buyer getting roped into a loan he or she shouldn’t have.
In the past few weeks, I have received several letters from readers who are considering getting mortgages with severe prepayment penalties attached to them.
One borrower was offered a 4-year prepayment penalty, known as a 4-3-2-1. That means if he sells or refinances in the first year, he’ll pay a 4 percent prepayment penalty on the loan. In the second year, he’ll pay 3 percent, 2 percent in the third year and 1 percent in the fourth year.
He needed a $250,000 loan, which means if he refinances or sells in the first year of the loan, he’ll pay $10,000. If you add in closing costs, a broker’s commission and other expenses, his property will need to increase about 15 percent in value in the first year just to break even. Otherwise, a good chunk of his equity in the property will evaporate.
And what’s he getting for taking on this risky kind of loan? A savings of a quarter percent in the interest rate. He’ll save about $100 per month.
But that loan is better than the one another elderly reader of mine wrote about. She was offered a loan with a 3-year 4 percent prepayment penalty. In other words, if she sold her home or refinanced anytime over the course of the first 3 years of the loan, she’d pay 4 percent.
On a $250,000 loan, that’s $30,000. Even if you close one day before the prepayment penalty period expires.
If you think no one is being offered loans like this, think again. It isn’t just subprime lenders who offer prepayment penalties. Like a hook with bait, conventional lenders use prepayment penalties to reel in prized borrowers — those with great credit scores.
In exchange for a quarter point dip in the interest rate, these folks are on the hook for two to four years. Landing that kind of fish puts a lot of chips in the mortgage lender’s wallet.
It’s clear that many borrowers don’t understand what prepayment penalties are and why they’re so bad. Or, they think that after a year or two, the penalty period will expire — but they don’t take the time to read the paperwork or the multiple disclosures they sign at the closing table.
Here’s the sorry truth: While prepayment penalties are prohibited by many states, they’re permitted by federally-chartered lenders. Who is a federally chartered lender? Any lender that has established its charter not in any one state but as a federal savings bank or under federal laws. Think of your major mortgage lenders, most online lenders, and local banks that have chosen to organize under a federal charter. It’s an end-run around consumer-protection laws put forth by the states.
If you’re considering getting a home loan that has a prepayment penalty attached, here’s what you need to know: A prepayment penalty means that you cannot sell your home or refinance within the penalty period without getting penalized. That penalty can be thousands of dollars. It can even mean that you might owe money to the bank above and beyond the sales price for the home.
There are no “ifs, ands, or buts.” Your lender won’t care if you get a job transfer, if your child gets sick, or you die. (If you die, your estate will have to pay the prepayment penalty out of the closing proceeds.)
You can still make extra payments toward the balance of the loan, but sometimes the amount of these prepayments is limited — you’ve got to read the pesky fine print.
The worst part about prepayment penalties is that they’re often associated with predatory lenders, lenders who are trying to catch you in a no-win situation with spiraling interest rates and no way out without forking over a huge cash payment.
I’d rather see you do almost anything than get a loan with a prepayment penalty. Know this: If you sign up for a loan that has a prepayment penalty period, you’ve just cut your financial options to one.
July 29, 2007.