Pre-Payment Penalties and Second Trust Deeds

Hello Mr. Melson,
Let me start off by saying that I am a big fan of your "Searchlight Crusade" website. I happened upon it a while back after I had already purchased my house. I've found a lot of useful information and I try to refer my friends and family to your site when they ask me home-buying/mortgage questions.

I am emailing you because I am considering a refinance. Just a little background info: I purchased a 3bedroom/2bath 1183 sq ft home in DELETED for $323,000 in Nov 2004. I am a DELETED with a credit score of 801. My wife is a part time DELETED with a credit score of 814.

I put no money down. I have my mortgage split into two loans (80/20). My first mortgage is $259K interest only with a rate of 5.375 fixed for 5 years with a payment of $1157.42. My second loan is about $64K HELOC interest only with what seems to be a monthly adjustable rate with my payments now close to $600. Both loans do not have a prepayment penalty. I've only been paying the interest every month. We plan to stay in the home for at least another three years (we are from out of state and might move back there when my son goes to high school - he's currently in the 5th grade). There is a possibility we might stay in DELETED at which point we're likely to stay in the house.

I was thinking about refinancing my HELOC so that the rate would be fixed. I spoke with my lender and I was offered a 15 yr loan with a fixed rate of 7.5% with a payment "around $600" with a prepayment penalty before 5 years.

Based on recent sales, my house is worth about $350K. Because of this I was told I could not refinance both loans into one.

Do you think it would be worth it to refinance. If so, what type of loan should I do? Or should I figure out if I'm staying in DELETED or moving back?

Any advice would be greatly appreciated.

I would love to give you my business if you know of anything that will work in my situation.

My first reaction was that there is no way anyone should accept a HELOC with a five year pre-payment penalty such as described.

You are going to need to refinance your first in November 2009 if not sooner. When that happens, there are going to be issues with subordination which are likely to cause you to want to pay your new second off, especially as the lender you mention has a policy of no subordinations.

This is an excellent question. Truthfully, an 8.00 or 8.25 percent Home Equity Loan (usually 30 year amortization, with the balance due at the end of 15 years in a balloon payment) will likely do better for you. Now my calculator says that a 30 due in 15 at 7.5 will have a fully amortized payment of $447.50, while a 15 year payoff is $593.29. Don't accept approximate payments, even as a quote - exact numbers tell you far too much about what's really going on. Also, you are and should remain at or below 95% Comprehensive Loan to Value (CLTV), which makes a difference on rate.

Some seconds have smaller penalties, so that may modify the answer. For instance, one lender I do a fair amount of business with has a very low closing cost second with a $500 prepayment penalty, in effect for three years. The cost to buy it off? $500. However, the standard prepayment penalty would be 80% of six months interest, or about $1920. Assuming you refinance in exactly three years, that boosts your effective rate by one full percent.

Now I'm happy to do whatever "stand alone" seconds come my way, a "stand alone" second trust deed being one where the primary mortgage is not being refinanced at the same time, as opposed to a "piggyback" where there is both a first and a second trust deed. However, the truth is that the best source for "stand alone" second mortgages is usually a credit union. I've got a couple of internet based lenders that are very competitive for high dollar value seconds, but for stand alone seconds below $75,000, credit unions rule. It was more cost effective to do our second with my wife's credit union than to do it myself. Just has to do with the mechanics of how brokers are set up and the way that most second trust deed lenders work.

Now you do have to be able to make those payments. But what you should really be paying attention to is the total cost of the money. How much in closing costs you have to pay to get the loan done, plus how much the loan is going to cost you in interest every month. It was only a couple of years ago that most traditional lenders would charge the same closing costs for a stand alone second that they would for a primary mortgage. For a $64,000 second, that $3500 in closing costs is almost 5.5% before you get to the actual interest charge - the equivalent of a 1.8% surcharge to the rate, assuming you kept it three years. You're better off taking a 9.5% rate that carries no closing costs than you are with an 8% rate that carries traditional ones, and that's not even considering the fact that you still owe most, if not all of that extra $3500, when you go to sell your house or refinance.

The situation, luckily for borrowers, has changed. Many lenders have very low cost stand-alone second trust deed programs, whether you are looking for a fixed rate home equity loan (HEL) or a flexible Home Equity Line of Credit (HELOC). The rates are higher than first trust deed loans, but the requirements are lower. Because the rates are higher, lenders are competing for these loans, with credit unions leading the charge. If there's a first mortgage involved, things are different. Most credit unions don't really have the resources to handle first trust deeds, with dollar values having appreciated the way they have. So they partner with major commercial banks, becoming essentially dedicated brokers for first mortgages, while competing ever harder for second mortgages in their own right. Nonetheless, because lenders want second trust deed loans, the result of their competing with each other has been a drastic drop in closing costs for second trust deeds over the past few years.

Caveat Emptor

UPDATED here