I write mortgage columns as a part-time job. My main job is running a mortgage company, consulting with borrowers, and keeping apprised of the ever-evolving myriad of mortgage products offered to the American consumer.
Back in the old days, mortgage products were limited. You could choose a 30-year fixed rate, a 15-year fixed rate, or a one-year adjustable. If you had some credit problems, you would have probably needed to visit a loan shark.
Today, there are programs for everyone. This is a good thing, as more choices to the consumer equates to a more personally tailored mortgage program. Today I'd like to write about an undesirable feature that is part of many new mortgage programs -- the pre-payment penalty.
A pre-payment penalty is simply a clause in your mortgage note that allows the lender to charge a fee if the loan is paid off within a specified period of time. Most pre-payment penalties expire within one to three years.
It's easy to see why some lenders want to slap a pre-pay on the loan. Consumers demand cheap loans these days, meaning they don't want to pay any points. As a mortgage broker, it would be hard for me to find a situation where I would actually recommend paying points to a customer. Lenders must accommodate such a market demand, so they offer to pay a mortgage broker a "yield spread premium" in exchange for a slightly higher interest rate. This enables the borrower to get into a loan with little fees and points.
The problem is that the lender doesn't want to fork out a few thousand dollars in order to make a loan that's just going to be paid off in a few months. Thus, the emergence of pre-payment penalties.
Let me give you a quick run down on what you might expect. First, check state law. Some states prohibit pre-payment penalties. If you live in one of these states, you won't have this problem, although your loans might be more expensive, but that's a different story.
Most pre-payment penalties don't exceed three years. A loan with a three-year pre-pay might carry the following terms:
- Penalty of three percent of the outstanding loan balance if paid off in the first year;
- Penalty of two percent of the loan balance if paid off in the second year;
- Penalty of one percent of the loan amount if paid off in the third year.
The penalty lessens the longer the loan is held. Also, most lenders will allow additional principal curtailments of up to 20 percent of the loan balance per year without a penalty.
And last, many pre-payment penalties apply only to a pay off as a result of a refinance. This means the homeowner may sell the property within the pre-payment penalty period.
Clearly, the terms of a pre-payment penalty described herein are designed to do one thing: prevent "refinance churning."
Another common pre-payment penalty that is a bit easier to stomach is a one-year pre-pay. Often called a "soft" pre-pay, you will probably find similar terms as the three-year pre-pay, with the penalty only lasting one year instead.
Prepayment penalties are not common in fixed-rate mortgages or balloons. However, you may find a penalty on some adjustable-rate mortgages, interest-only payment mortgages, and higher interest rate, alternative credit loans.
The bottom line is this: First determine the mortgage product that best suits your particular objectives. If that product contains a penalty for early payoff, understand the terms completely. Then decide if you can live with the terms. If you can't, your competent loan officer will be able to give you other viable options.