Avoid Prepayment Penalty

Q: I am a mortgage broker in Wheaton, Illinois. I am refinancing a mortgage for some friends of mine and in doing the research on their loan, I found that they agreed to a mortgage in 1991 that has a prepayment penalty for 5 years.
 

The interest rate on their loan 7.125 percent for a 30-year fixed and their credit scores are in the 800s. But the penalty is $5,700 if they refinance. Is there anything I can do to help these people?

A: I’m a little confused. You said they have a prepayment penalty from 1991 that would only be good for five years. But 1991 is 13 years ago so the prepayment penalty would have expired. I’m assuming you meant that their loan is from 2001, so the prepayment penalty wouldn’t expire until 2006, or just over a year from now.

With that as a starting point, as a mortgage broker who probably deals with prepayment penalties all the time, you know that prepayment penalties are probably enforceable even though they're technically not permitted in Illinois, as in other states.

What you should do is tell your friends you can't refinance them now unless they pay this huge fee. Educate them on what a prepayment penalty is (they probably can't even sell their home) and make sure they did indeed initial the prepayment penalty page on their loan. If they didn’t, or if the loan was made without the prepayment penalty paperwork but reported as having it, you may be able to get around it.

You can try pleading the case with their lender, but I don't think you'll have much luck. Hopefully, next time they'll be more careful.

But this is a great example of why I’m against getting a prepayment penalty in exchange for a slight break on the interest rate of a loan. Prepayment penalties typically prevent you from refinancing or selling your home and paying off the loan within the penalty period. A five-year penalty period is longer than normal – I typically hear about 2 to 4 year penalty periods.

But while you’re in the penalty period, your options are extremely limited – and if you have to sell or refinance your home, you’ll pay through the nose.

One thing you might want to check on is whether the terms of the loan allow for partial prepayments without a penalty. Some loans allow a prepayment of up to twenty percent of the loan amount per year without a prepayment. Your friends might be able to prepay a portion of their loan and get an equity line for that amount and pay a lower interest rate. Then, when the prepayment term is up, they can refinance the entire loan.

If a lender tells you the loan carries a prepayment penalty, take a pass.

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