Prepayment Penalties Haunt Many Refinancers

Chicago Tribune
April 13, 2005

By Marilyn Kennedy Melia

How would you have answered this recent question from a reader: "I have a $73,000 second mortgage and the interest rate is 12.75 percent. Should I refinance?"

Of course, you'd tell the reader to get rid of that expensive loan. Double-digit rates like that are a relic of the past.

Well, not everyone finds it economical to refinance. Some homeowners with second mortgages, and most homeowners who had credit troubles when they took out their mortgage, have to pay a fee when they pay off their loan. The fee, known as a prepayment penalty, comes into play anytime a loan is repaid, whether someone is selling or refinancing.

The penalty can be hefty enough to inhibit refinancing. Traditionally, refinancing is considered economical if all the upfront costs can be recaptured in a reasonable length of time through the monthly savings on a lower rate loan. A borrower may choose not to refinance if he or she has to pay several thousand dollars in a penalty charge, for instance.

Borrowers who could benefit the most from lowering their interest rate are often the ones subject to prepayment penalties. That's because the penalties are only common in "subprime" mortgages, the industry term for higher rate loans to borrowers with poor credit histories. Subprime loans carry higher rates to compensate lenders for taking the risk of lending to people with credit troubles.

The reason many subprime mortgages also carry a prepayment penalty is that lenders spend more time originating these loans, says Jeffrey Zeltzer, executive director of the National Home Equity Mortgage Association, a Washington, D.C., trade group for subprime lenders. Once they spend extra time making the loans, lenders don't want them quickly repaid. Still, while it's widely acknowledged that lenders need extra compensation for riskier borrowers, consumer advocates say some rates and fees cross the line into illegal "predatory" lending.

In fact, an Illinois state law prohibiting predatory lending limits prepayment fees to 3 percent of the loan amount during the first year, dropping 1 percentage point in each of the following years, so that the loans would have no penalty by the fourth year. However, the law governs only loans with extremely high interest rates. One could presumably have a bigger prepayment fee than the legal limit if the loan's interest rate is not extremely high.

Not only can they be expensive, but prepayment penalties are often a costly surprise, asserts Amalia Nietogomez of the National Training and Information Center, a Chicago homeowner advocacy group. "A lot of people don't find out they have one until they try to pay [their mortgage] off." (These terms are, however, written into the mortgage agreement, which borrowers should read and understand before they sign it.)

Prepayment penalties are also common enough in home equity loans that borrowers should make sure they inquire about the fees before taking a loan, says Fritz Elmendorf of the Consumer Bankers Association, a trade group in Arlington, Va. Home equity lines of credit don't usually carry prepayment penalties. However, equity lines, which differ from loans in that they allow borrowers to write checks up to a certain amount rather than receiving a lump sum, may have inactivity fees that are levied if borrowers don't use the line actively, Elmendorf notes.

The National Home Equity Mortgage Association is urging its members not only to inform borrowers about prepayment penalties, but also to give borrowers the option of taking a mortgage without a prepayment provision, albeit at a slightly higher interest rate, Zeltzer says. While once nearly all subprime loans carried penalties, now many are available without them.

It can sometimes be difficult for subprime borrowers to decide whether to take a loan with a penalty. "With a penalty, you might get a mortgage as much as 1 percent lower," says Bud Frase, president of HomeTown Mortgage, Libertyville. "But then you have to consider if you're going to move, or if maybe your credit will improve and you can refinance into an even better rate."

Increasingly, Zeltzer says, the subprime loan business is adopting the prepayment penalty outlined in California law, which requires 6 months' interest on 80 percent of the loan balance anytime a mortgage is paid off within three years.

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