The Internet has been humming with a new mortgage debate in Washington: With apologies to Shakespeare, to have prepayment penalties or to ban them, that is the question of the day.
On August 15 and within five minutes of each other, e-mail arrived from the Mortgage Bankers Association and the National Association of Realtors arguing both sides of the issue.
Saying that “abusive lending erodes confidence in the nation’s housing system,” NAR told the Federal Reserve that “prepayment penalties often trap borrowers in loans they cannot afford by making them too expensive to refinance. While some lenders may, in fact, offer lower rates in exchange for a borrower agreeing to a prepayment penalty, in the experience of many Realtors, that option is not typical. A 2005 study by the Center for Responsible Lending concluded that borrowers with subprime loans and prepayment penalties do not receive lower interest rates, and may actually pay higher rates.”
NAR then went on and said “the use of prepayment penalties with terms that extend beyond the initial fixed interest rate period that is a feature of many adjustable rate mortgages is particularly egregious. Some originators encourage consumers to accept these loans by reassuring them that they can always avoid a jump in payments by refinancing before the reset period. But then, when they do refinance, assuming they can in the current credit environment, the lender charges a prepayment penalty. This is one of the most unfair practices engaged in by irresponsible lenders.”
The Mortgage Bankers Association offered an entirely different view. They argued that “prohibiting or significantly restricting prepayment penalties can be expected to increase rates to borrowers and would eliminate certain financing options for consumers. MBA supports the limitation of prepayment penalties to three years for all mortgage loans and expects that the market will conform to the recent subprime statement requiring prepayment penalties not extend beyond the reset period of hybrid ARMs and allow borrowers a period of up to 60 days prior to the initial ARM reset to avoid a prepayment penalty.”
If the question were one of “either/or” you would certainly have borrowers backing the NAR position in overwhelming numbers. But while the NAR position is plainly more popular, it still requires some tinkering because there is one important instance where prepayment penalties are justified.
Imagine that you get a $200,000 loan. You want to hold down closing costs so the lender offers a trade: We’ll pay most closing costs if you accept a somewhat higher rate.
By “most closing costs” the lender means that it will pay all settlement expenses except prepaid items such as tax and insurance escrows, mortgage insurance, HOA/Condo fees and mortgage insurance premiums. The lender won’t be responsible for owner’s title insurance coverage or any charges to pay off an existing loan.
In this situation — commonly and incorrectly called a “no-cost” loan closing — there are surely expenses. For the borrower the costs of closing are paid over time in the form of a higher rate. For the lender, the costs are paid up front, perhaps $5,000 or more depending on the jurisdiction where the property is located.
“When the lender pays all closing expenses without increasing the loan balance then a prepayment penalty is fair because the lender should have an opportunity to recoup its actual cash costs,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s leading foreclosure marketplace. “We need to work out a system which preserves the so-called “no cost” closing option while giving lenders a fair opportunity to recover their up-front expenses.”
As to a prepayment penalty period, three years — with a qualification — seems like a fair time for the lender to recover its costs. The qualification is this: The prepayment penalty in month No. 1 should not be the same as month No. 36.
As an example: Imagine that you have a subprime loan with a $200,000 balance and a six-month prepayment penalty if the loan is paid off at any time during the first three years. The loan has a 9 percent interest rate and because of improving credit you have a chance to refinance down to 7.5 percent after two years. The prepayment penalty is $9,000, money due at closing when the loan is refinanced. ($200,000 x 9% = $18,000. $18,000/2 = $9,000).
For most borrowers, especially those trying to end subprime mortgages and their steep rates, a $9,000 penalty is an impossible barrier, something which cannot be overcome. The result is no refinancing during the penalty period and vastly higher costs month after month.
Prepayment penalties have a huge impact on effective interest rates. For instance, if the loan is refinanced after two full years, the borrower paid interest worth $17,944.55 in the first year, $17,816.37 in the second and a $9,000 penalty. That’s a total cost of $44,760.92 over two years — an effective rate of roughly 11.2 percent.
Regardless of what the big print says, our model loan never has a 9 percent rate during its first three years. Why? Because if a borrower wants to refinance to a lower rate, sell the property or pay off the loan during the prepayment period, the actual cost of the loan is substantially greater than the quoted rate. Instead of an up-front teaser rate, what we really have is an inverse-rate loan, financing with a higher start cost and then a lower interest level at the end.
What About Discounts?
It’s sometimes argued that borrowers should accept a prepayment penalty in exchange for a lower rate. Superficially, such a trade seems reasonable, but the borrower is dependent on the mortgage lender for rate information. Since rates are in constant flux and because different rates apply to different loan products and borrowers with different credit profiles, there is no set interest level to discount. Because the borrower does not know the benchmark interest rate for a given combination of loan factors, there’s no evidence — as NAR reports — that there has been a particular discount, or in some cases any discount.
The idea that lenders are offering a discount would have greater credibility if loan officers had a fiduciary duty and borrowers were their clients. As agents of a borrower, lenders would be required to obtain the best possible rates and terms for borrowers. Instead, lenders argue fiercely that it’s not their job to advance borrower interests.
“Some have proposed that a fiduciary duty standard should be implemented and mortgage originators and their loan officers should act in the ‘best interests’ of the consumer,” Harry Dinham, president of the National Association of Mortgage Brokers, told Congress. “NAMB remains opposed to any proposed law, regulation or other measure that attempts to impose a fiduciary duty, in any fashion, upon a mortgage broker or any other originator.
“Simply put, a mortgage broker should not, and cannot, owe a fiduciary duty to a borrower. The consumer is the decision maker, not the mortgage broker,” Dinham said.
But how can a borrower make an informed decision when lenders have all the information and borrowers are dependent on lenders? The parallel situation in real estate works like this: A property owner is promised 100 percent of a given sale price. If the target is met the broker’s commission is equal to everything above the target value. Such an arrangement presumes that the borrower knows the value of his or her property, a presumption so absurd that so-called “net listings” for residential properties are illegal in most if not all states.
What Happened To Good Credit?
There’s substantial evidence that the benefits of good credit are not being passed through to mortgage borrowers.
James Lockhart, the Director of the Office of Federal Housing Enterprise Oversight (OFHEO), the regulator that oversees Fannie Mae and Freddie Mac, says that “subprime originations market share almost tripled from 7.2 percent in 2002 of total originations to 21.4 percent in 2006.” Meanwhile, FHA originations fell from 1,246,561 loans in 2002 to 502,000 mortgages in 2006.
The Census Bureau has just reported that median household income amounted to $48,200 in 2006 and that the poverty rate is down from 12.6 percent in 2005 to 12.3 percent in 2006.
How can it be that the number of people with “weak” credit tripled in the midst of good economic times and one of the largest real estate growth spurts in U.S. history? Could something else be at work?
One reason for subprime growth is simple: Borrowers who qualify for lower-cost FHA financing are being steered to higher-cost subprime loans. Why? Lenders get far larger profits. (For an interesting look at lender economics, see: Inside the Countrywide Lending Spree, The New York Times, August 26, 2007.)
The same scenario is also true for stated-income loan applications. By using stated-income apps lenders charge higher fees — including higher fees for employed borrowers who can readily document their income but do not know that such an option exists. You can’t, of course, use a stated-income loan application for an FHA mortgage and therefore as a broker you can’t get the higher rate or additional fee available with a subprime loan.
What About Investors?
The argument is made that if prepayment penalties are restricted or prohibited then investors will no longer purchase mortgages.
Some investors will surely take their money elsewhere if the prepayment system is changed — but where? After the stock market lost some $5 trillion in its most recent crash, some investors plainly left the market — but the market continued, most people stayed invested and the Dow today is substantially above the pre-crash high of 11,722.98 reached during January 2000.
The U.S. mortgage marketplace now involves trillions of dollars. If investors leave, where will they put their money? It’s difficult to see trillions of dollars deposited in local passbook savings accounts or uncertain foreign assets. The overwhelming majority of U.S. mortgages — including subprime loans — are being paid off, reason enough to keep funds in such investments.
The Case For Declining Prepayment Penalties
Instead of a flat, one-size-fits-all penalty at any point during the penalty period, a lender should be entitled to a prepayment penalty equal to 100 percent of its actual cash closing costs only in month No. 1. Each month thereafter the size of the penalty should decline by 2.778% until it reaches zero. (2.778% x 36 = 100.008%)
Why? Because each month the lender has a chance to get interest from the loan — and the trade with a “no cost” mortgage was more interest for reduced costs up front. Having a $5,000 penalty in month No. 1 may make sense, but not in month No. 36.
As to $9,000, if that sum exceeds the cash payment made by a lender at closing then it’s simply excess, unearned and unjustified profit for the lender; a cost unrelated to any borrower benefit and an expense made possible only because the lender has more leverage than the consumer.
“There’s also a very practical, market-driven, reason for both borrowers and policy makers to favor ‘no cost’ mortgages,” Saccacio explains. “Lenders do a lot of loans. They have economic power in the marketplace. They can force down expenses for settlement services in a way that individual borrowers cannot. A lender who does 500 loans with a settlement provider is going to pay a lot less per closing then an individual borrower. If settlement costs are reduced that means lenders get back their cash investment faster and borrowers face smaller prepayment penalties.”
As to prepayment fees for loans where the lender is not paying up-front costs, as the old expression goes, “forgetaboutit.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.