Prepayment Penalties in Subprime Loans

EACH YEAR, PREPAYMENT PENALTIES IN SUBPRIME LOANS CAUSE 850,000 FAMILIES TO LOSE $2.3 BILLION IN HOME EQUITY WEALTH.

What is a prepayment penalty?

A prepayment penalty is a fee required by the lender when borrowers pay off a mortgage loan early. In the subprime mortgage market, where borrowers tend to have less-than-perfect credit, an abusive prepayment penalty can trap them in a high-interest loan even after they improve their credit rating. When borrowers qualify for a better loan, even several years later, they are charged a large fee to pay off their old loan. This penalty is seldom imposed in the conventional mortgage market.

Who is affected by prepayment penalties?

The majority of borrowers who obtain loans in the subprime market receive prepayment penalties. In fact, many borrowers, regardless of their credit, are "steered" to such loans. Unscrupulous lenders -- typically, mortgage brokers working with unsupervised finance companies -- target our most vulnerable citizens: minority groups, working families of all backgrounds, and the elderly.

What is the cost of a prepayment penalty?

One common penalty costs six months' interest on the loan if the borrower prepays in the first five years (roughly 4-5% of the original loan amount). Particularly for families that struggle to make regular monthly payments on time, paying thousands of dollars to get out of a loan represents an overwhelming expense, and can prevent them from obtaining a more affordable loan as their credit improves. In 2001, based on industry assumptions on prepayment patterns, CRL estimated that 44% of borrowers pay a 4% fee in the first four years of the loan. Given $160 billion in 1999 subprime originations, CRL estimated that 850,000 homeowners per year lose $2.3 billion in equity per year.

Do prepayment penalties help subprime borrowers get lower interest rates?

Some lenders say that prepayment penalties offset the cost of early payoffs, allowing them to offer lower interest rates. However, in most cases, there is no evidence that borrowers with prepayment penalties actually receive a break on their interest rates. In fact, because penalties often are coupled with kickbacks, just the opposite may be true. Research indicates that any interest rate savings realized by the borrower tend to be significantly outweighed by the costs of the penalty. Even a conservative estimate shows that the typical cost to the average borrower is three to four times more than the savings in interest payments.

Don't consumers choose prepayment penalties?

If these types of loans were freely selected, one would expect consumers to choose them at about the same rate in the subprime and prime lending markets. However, in the competitive conventional mortgage market, only 2% of mortgage loans impose prepayment penalties. In the subprime market, the figure is 80%. Borrowers, who are focused on the interest rate and monthly payment, often are unaware of the prepayment penalty -- an obscure clause buried in a large stack of documents.

The Kickback Connection

When a mortgage broker originates a loan that carries a higher interest rate than the rate set by the lender, the lender sometimes pays a "yield spread premium" -- a kickback for delivering a more expensive loan. Lenders are more willing to pay kickbacks on loans with prepayment penalties. As a result, loans in the subprime market are more likely to come with prepayment penalties, and brokers have a clear incentive to persuade borrowers to accept excessively high interest rates and loans with prepayment penalties.