Home Buyers Lose a Useful Mortgage Option to Overzealous Regulation

August 14, 2016 

Before the financial crisis, many mortgage contracts contained a provision stating that borrowers who paid off their loan early had to pay a penalty. Penalties were usually expressed as a percent of the outstanding balance at time of prepayment, or a specified number of months of interest. In most cases, the penalties declined with the passage of time, and usually disappeared entirely after 5 years or so. Partial prepayments of up to 20% of the balance usually were allowed in any one year without a penalty. Sometimes the penalty applied to a home purchase transaction as well as a refinancing, but more commonly it applied only to a refinance. 

Prepayment penalties were never allowed on FHA or VA loans, but after the financial crisis Fannie Mae and Freddie Mac also barred them. Today, penalties are permitted only in the remaining sliver of the market not touched by the Federal agencies – which is no more than 10% of the total. Many say “good riddance” but I view it as the loss of an option that some borrowers could use to their benefit. 

Prepayment Penalties as a Useful Option

Here is a letter I received before the financial crisis: 

"We are committing ourselves up to the limit of our capacity to buy the house we want. Our broker said we could reduce the rate from 7% to 6.75% if we accepted a prepayment penalty. This would reduce our payment by $35 a month, which would help a lot. Should we?"

This offer was typical at that time.  Lenders, and the investors who purchased loans from lenders in the secondary market, were willing to accept a lower rate in exchange for a prepayment penalty. The benefit of a prepayment penalty to them was that it discouraged refinancing if interest rates declined in the future. The borrower received the immediate and concrete benefit of a lower rate, and gave up the right to refinance freely when and if the opportunity presented itself.  

So why has this useful option gone away? One reason is that the penalties were widely used in  connection with sub-prime mortgages, with resulting guilt by association. 

Guilt by Association: Prepayment Penalties on Sub-Prime Mortgages 

Here is another pre-crisis letter:

"Because I have very bad credit, I agreed to pay 11% for a 30-year mortgage. Friends have warned me to avoid a prepayment penalty, but when I ask the loan officer about this, he says that the lender absolutely requires it. Do I have any options?"

I advised this borrower at the time that he might be able to negotiate a less burdensome penalty clause but that he would not be able to rid himself of it entirely.  Lenders generally demanded prepayment penalties on sub-prime loans because the risk of refinancing was so high. As with prime borrowers, sub –prime borrowers could refinance if market rates went down, and they could also refinance if their credit rating improved, even when the general level of mortgage rates did not change. For example, I estimated that if this borrower made all payments on time for 2 years, and assuming no change in the general market, he might be able to refinance an 11% loan into a 7-8% loan. Because of high origination costs and high default costs, sub-prime lending was not profitable if the good loans walked out the door after only two years.

When the sub-prime market collapsed under the weight of declining home values and rising foreclosures, the negative fallout associated with everything “sub-prime” extended to the onerous prepayment penalties that were part of every such loan. This was the “guilt by association”. 

Many Prime Borrowers Were Never Offered the Option

The sub-prime experience might not have had the impact it did if the practice of offering a prepayment option on prime loans was widespread, but it was not. Loan officers usually press to close a transaction as soon as possible, and offering options slows down the process. The upshot is that during the years that Fannie Mae and Freddie Mac allowed prepayment penalties, many prime borrowers who would have selected a prepayment option if it had been offered, never had the chance. In addition, some prime borrowers years later found themselves with a prepayment  penalty for which they had received no  compensation.

Contract Chicanery Often Involved Prepayment Penalties

Contract chicanery is the practice of surreptitiously slipping a provision disadvantageous to the borrower into the mortgage note. Ordinarily, the borrower does not see the note until shortly before the closing, and probably does not read it then. Before the financial crisis, prepayment penalties were the most common objective of contract chicanery. This is despite the fact that the mandatory Truth in Lending form received by every borrower had a section on prepayment penalties.  The disclosure was so ambiguously worded, however, that many borrowers who read the disclosure missed the point.  Readers interested in how poor disclosures can be worse than none can read Disclosure Rules on Mortgage Prepayment Penalties.

Concluding Comment

The sequence of events described above can be generalized as follows:

1.  An option useful to some borrowers is used by some lenders to abuse other borrowers.

2.  Regulators fail to curb the abuses through mandatory disclosures or other devices that would allow the option to continue.

3.  So the regulators eliminate the option.

In my view, this amounts to regulatory failure. Such failures are not limited to prepayment penalties, and in the weeks ahead I will discuss some other areas where it has happened.

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