Although a number of states have outlawed them, and savvier buyers have shunned them, prepayment penalties are thriving in one area of the mortgage business – those borrowers with less than perfect credit.

A prepayment penalty is basically a fine for paying off your loan early. Most of the time, prepayment penalties are structured like this: If you pay off your loan within the first 3 or 4 years, you’ll have to pay 2 percent of the loan amount as a fee for the lender agreeing to allow your loan to be paid off.

While that sounds outrageous, lenders will offer you something in order to get you to agree to attach a prepayment penalty to the loan, like a quarter or half point reduction in the interest rate of the loan.

Mostly, prepayment penalties are used to adjust the risks of making the loan, including the risk that it might be paid off sooner than the lender expects or the risk that the borrower will pay late or will stop making mortgage payments altogether.

By locking the borrower into a tough prepayment penalty, the lender is trying to guarantee a stream of income for at least 3 or 4 years. Over the past few years, as interest rates dropped to historic low levels, the typical 30-year mortgage was paid off in 12 to 18 months, instead of a more typical 7 to 8 years. As a result, some lenders lost money on these loans.

An even bigger risk is that the borrower will pay late or stop paying the mortgage altogether. It’s an accepted fact in the mortgage industry that borrowers with less than perfect credit are at a greater risk for foreclosure than borrowers with perfect credit.

That is why prepayment penalties are flourishing in the subprime market, according to Rod Alba, senior director of governmental affairs for the Mortgage Bankers Association of America (MBA).

“Subprime lenders find prepayment penalties a useful way to lessen some of the risk involved with making subprime loans,” Alba said. “Where the consumer has credit dings, the risk profile of the consumer is sufficiently high that a prepayment penalty allows the lender to lower the risk on the loan and make the loan.”

In the subprime market, lenders use prepayment penalties in different ways, Alba explained. “If there’s no prepayment penalty, the borrower might pay 1.5 points (a point is one percent of the loan amount) upfront. With a prepayment penalty, there may be no points.”

A lender might also use a prepayment penalty to help lower a mortgage interest rate to a level that will allow the borrower to qualify for the loan.

“If you opt out of the prepayment penalty, you might pay a half point (one half percent) more in interest,” Alba said.

Although prepayment penalties must be disclosed in writing when applying for a loan and at the closing, the documents can be tough to read and understand. While borrowers might understand that a prepayment penalty precludes them from refinancing the loan within the penalty period, they often don’t understand that having a prepayment penalty also means they can’t sell their home.

When you sell your home, you have to pay off the loan with the proceeds. But limiting your ability to sell your home is a reality many homeowners don’t understand until it is too late.

Another problem with prepayment penalties is that they are the tool of choice for predatory lenders. Instead of using a prepayment penalty to lessen the risk a higher-risk borrower will go into foreclosure, a predatory lender will use a tough prepayment penalty to lock the borrower into bad loan situation and keep him or her there for years to come.

“Are there market abuses? Absolutely,” admits Alba. “We would say, at the MBA, that any time you have a prepayment penalty that was not properly disclosed to the consumer and was not necessary or required for the transaction it’s an abuse. It shouldn’t be there.”

But if you’re the borrower and your lender is telling you that you can’t get a loan without a prepayment penalty, how do you know it’s an abusive situation?

According to Alba, borrowers have to shop around, read their documents, and understand exactly the prepayment penalty disclosure: If you have a prepayment penalty attached to your loan, you cannot pay off the loan before the penalty period is up, or you have to pay. And, that includes selling your home.

In one of the most frequent scams, predatory lenders tell borrowers that their loans do not carry prepayment penalties, then slip the disclosure paperwork into the myriad of other papers they have to sign at the closing and hope the borrower doesn’t notice.

That is why you have to read all of the documents before you sign them. If you were told your loan did not have a prepayment penalty and at the closing you’re asked to sign a prepayment penalty disclosure, you’re being railroaded.

And don’t think you’ll be able to get out of your prepayment penalty later on with a sob story. Lenders have heard it all before. In addition, prepayment penalties continue with the loan until they expire, even if your lender sells the servicing rights for your loan to another company.

“When a lender sells a loan, all of the underlying contractual relationships, duties, responsibilities and rights remain exactly the same,” Alba noted. “The only thing that should change is the address to which you’re paying the loan.”

The only thing that works against an abusive prepayment penalty situation is knowledge: You have to know what your credit history is, what your credit score is, and what your options are before you sign on the dotted line.

Feb. 13, 2004.