Under the Mortgage Microscope: Prepayment penalties understood.

Despite consumers dislike for prepayment penalties lenders often make them a requirement of the loan.  Nobody wants one; nobody likes them.  So why can’t we just get rid of them altogether?  My rule of thumb is to generally avoid prepayment penalties when possible, but is there ever a time when it’s advisable to accept a prepayment penalty? 

To answer this, we need to look at the big picture so that we can better understand the role of prepayment penalties in a loan.  Sure, prepayment penalties exist to protect the lenders profit margin on a loan, but a closer look reveals that the driving force behind prepayment penalties is the need to lend in a marketplace that would otherwise not exist.

Say for example a lender has $25M to lend.  They can choose to lend that money to borrowers with strong credit scores and make a profit margin of 2-3%, or they can choose to lend this money to higher risk – low credit score borrowers and make higher profit margins of say 4-5%. 

Herein lays the reason for the prepayment penalty.  Without a mechanism to tie a borrower to a loan for some pre-determined period of time, the lender bears the risk of losing the intended profit margin which is the driving force behind their willingness to provide loans to individuals with less than perfect credit histories.   In other words, why lend money to higher risk borrowers if there’s no additional gain. 

It’s for this reason that sub-prime loans contain a pre-payment penalty.  However the penalties are not exclusive to the sub-prime borrower.  Often you will find A paper borrowers that have a penalty.  In these cases it can be for other reasons.  Remember, just because a borrower has “A” grade credit it doesn’t mean they qualify for an “A” grade loan, many other factors are in play.  The type of income documentation provided, and the loan to value ratio, are some of the reasons why an “A” borrower may have a loan that requires to have a prepayment penalty.

So Should I accept a prepayment penalty?

No.  Avoid prepayment penalties any time that you can.  Remember, the penalties are there for the lenders sake not yours.  Sometimes you will get a lower interest rate for accepting a penalty, but this rate reduction needs to be weighed heavily against your ability to get out of this loan if necessary.  Most people can reasonably forecast their lives for the next year and a 1 year prepayment penalty is pretty safe bet.  However, anything longer than a year has too much uncertainty.  Take into consideration that a family hardship, the loss of income, or any unexpected reason requiring you to sell or refinance the property will likely cost you thousands of dollars if you trigger a prepayment clause.  Therefore the savings associated with a rate reduction will be eaten away by the penalty should you trigger it.

If your credit score and borrowing situation is such that you can’t get around a prepayment penalty, then you have no choice but to accept it. However, before you accept a penalty, you need to be certain that you understand it and can live with the loan as it is for the duration of the penalty period.  

Generally, there are 2 types of prepayment penalties, Hard and Soft and they can range from 1-5 years in length.   

A hard penalty means that if you refinance or sell the property, the penalty will be invoked and you will have to pay the lender..

A soft prepayment penalty means that the borrower can sell the property without penalty however if they try to refinance the property, the penalty will apply.

So needless to say prepayment penalties will always exist as long as there is a market for lending to anyone other than the perfect borrower.   

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