Prepayment Penalties: Why Would You Want One?
I hear this often when discussing loan programs with clients, "David, there's no prepayment penalty on this loan is there?" Usually, no, but there may be times when a prepayment penalty makes sense.
How can this be?
First, exactly what is a prepayment penalty? It's simply interest funds paid to the lender should the mortgage be retired before an agreed upon term. If you have a 15-year mortgage there's a financial penalty to the lender should you pay off the loan before it's full term. Such penalties vary, but a typical penalty is six months worth of mortgage interest. Most loans with prepayment penalty clauses typically apply during the first three to five years only, with no penalty thereafter. And some states outlaw them completely or place restrictions on them.
There are usually two types of mortgage loans that carry prepayment penalties, sometimes given the monikers "hard" and "soft."
A hard penalty is one that applies to the loan throughout the term, regardless of how the mortgage was retired. Refinancing, selling the home or even making additional principal payments usually define a hard prepayment loan type. Hard prepayments mostly apply to offset other borrower factors like damaged credit or hard to prove income -- and to assure that the lender gets as much interest as possible from the loan.
Less costly, is the soft prepayment. Soft prepayment clauses usually last only 36 to 60 months and do not apply if the house is sold, only if refinanced. Further, most soft prepayment loans allow for extra payments to principal so long as the extra payments do not exceed 20 percent of the principal balance during any 12-month period. On a $100,000 mortgage, you can usually pay off $20,000 extra per year without penalty. Soft prepayments usually are designed to offset a lower initial rate -- in effect, they give the lender some time to re-coup that low up-front rate.
So why do consumers take such loans?
A hard prepayment penalty may apply with a loan issued to someone whose credit is under repair and represents a higher risk of default. In exchange for making a loan under these circumstances, a lender wants to assure a certain return over the life of the loan. Consumers are less likely to pay off a prepayment penalty loan if they have to come up with 6 months interest at closing.
Soft prepayments are sometime offered for the same reason, to insure a specified return on a mortgage loan, but to a borrower with excellent credit. Why would someone with perfectly good credit accept a loan with prepayment penalties?
To get a lower interest rate!
A typical 30-year fixed mortgage could be reduced by .25 percent should the borrower elect a prepayment loan. Usually those who choose a lower rate with a prepayment penalty are planning on keeping the home for an extended period, don't see a need to refinance in the next 3 to 5 years, and realize that if rates go marginally lower it may not pay to refinance. This strategy can be more beneficial for borrowers in times like these with low rates and little likelihood of rates going much lower.
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