Buying off a Prepayment Penalty

Been reading some of your informative tips. I am looking at refinancing and getting a $378000 mortgage. Now in the case of having a 3 yr prepay penalty, vs paying 1.5% in points to make it a 1 yr prepay, am i right in assuming it's wiser for me to pay the points than accept a three yr prepay when i know I will sell/move within 2 yrs? Any info you can provide would be great. I'm wondering if I'm missing something here.

I think they points would cost me around $5800.

I compute 1.5 points on $378,000 as being approximately $5756.

Here in California, the maximum pre-payment penalty is six months interest, and that is the industry standard nationwide for when there is a pre-payment penalty. A few lenders will pro-rate it, but for the vast majority, they will charge the same penalty on the day before it expires as on day one. This is pure profit, and they're generally not going to turn down pure profit any more than most people will turn down a bonus. So if your interest rate is 6 percent, you're going to pay a 3 percent pre-payment penalty if you sell or refinance before the pre-payment penalty expires. For Negative Amortization loans, the pre-payment penalty is based on the real rate, not one percent, of course.

On some loans, the pre-payment penalty is triggered by paying any extra money. One extra dollar and GOTCHA! But probably eighty percent or so give you the option of paying it down a certain amount extra each year, usually 20 percent, without triggering the pre-payment penalty.

Assuming that it is a case of you won't move in less than one year, this is equivalent to the prepayment penalty on a loan with interest rate of between 3.05% (100 percent prepayment penalty) and 3.81% (80% prepayment penalty). Since even the 1 month LIBOR is a little over 3.8 percent right now, this seems like a cut and dried case of pay the point and a half.

Of course, if there is a possibility that you will need to move in less than one year, paying these 1.5 points could well be a costly exercise in futility. I can't begin to gauge that risk without more information. But if you're in any number of professional situations ranging from the military to corporate executive, this is common.

Given that you're talking about pre-payment penalties, you're likely in a subprime situation. Subprime has a fairly uniform rate of 1.5 points of cost equals 3/4 of a point on the interest rate. I'm going to assume you're getting about a 6.25% rate. If you decided to buy it off via rate, you'd be looking at a 7% rate.

Let's punch in the two loans. $383,750 (balance with 1.5 points) at 6.25% gives you a payment of $2362.81. Running it out 24 months gives you a balance of $374,467. You have spent $56,708 on payments.

378,000 at 7% gives you a payment of $2514.84. Running it out 24 months gives you a balance of $370,043.00, and you've spent $60,356 on payments, while paying your balance down $7957.

Now, assume you sell the home for $X at the end of this period. The first loan saves you $3648 in interest. The second loan gives you $4424 more in your pocket in two years. The second loan, with the higher interest rate and higher payment, as opposed to the higher balance, nonetheless saves you $776 as opposed to the loan with the lower interest rate, and also leaves you more money with which to buy your next home, which means lower cost of interest on your next home loan, as well. Of course, this is subject to some pretty significantly naked assumptions as I don't know anything more about your situation. Furthermore, it assumes that your income is not marginal, and that you would qualify for both loans. It is perfectly possible that you would qualify for the lower payment, and hence the lower rate would be approved, but not be able to qualify for the higher payment associated with the higher rate (The reverse is not the case). Finally, I assumed that because you know you're going to have to move in two years, you are looking at a two or three year ARM in the first place, as opposed to a longer fixed term.

I hope this helps you. If you have any further questions, please let me know.

Caveat Emptor

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