Getting Out of Paying Pre-Payment Penalties

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I got a search result for how to get out of mortgage pre-payment penalties, although I've never really dealt with the issue.

Prepayment penalties on real estate loans are something some people, often with less than stellar credit, accept, either in order to either get their mortgage rate lowered or because they don't know any better, or because they didn't ask, were lied to, didn't stick to their guns, didn't protect themselves from unethical loan providers, or any of a dozen other reasons people end up with them. Standard prepayment penalties are six months interest on the outstanding balance, but many companies with "twenty percent" allowances only require eighty percent of that.

Prepayment penalties come in two major varieties, "hard" and "soft", with the vast majority being hard prepayment penalties. Hard means that if the prepayment happens for any reason, you will pay the prepayment penalty. Soft means that if the reason you pay early is because you actually sold the property, there will be no prepayment penalty due.

Prepayment penalties can be further sorted into "first dollar" and "twenty percent". Either can be in the contract for either a soft or hard prepay, but first dollar prepays are uncommon for soft prepayment penalties. If you have a "first dollar" prepayment penalty and you pay one extra dollar above your regular payment, you will be assessed the penalty. These are most common with Negative Amortization loans, and are somewhere between ten and twenty percent of all prepayment penalties, judging from my experience with the problems people bring to me. A so-called "twenty percent" penalty allows you to pay up to twenty percent of the loan balance in any given year without triggering a penalty.

Common terms for prepayment penalties are one, two, three, and five years, although I have seen ten. Since the median time between refinancing is less than two years, and ninety-five percent of everyone has refinanced or sold within five years, it's very much like a hidden fee to the bank in most cases, one that will not appear on your loan costs summary of the HUD 1, and yet since most people who accept them end up paying them, I would certainly advocate disclosure of a dollar value being mandatory if there is a prepayment penalty associated with a loan. This is not to say that they are never beneficial or never necessary, but in a large majority of all cases they are simply the result of a loan provider who wants to make more money, who hides the prepayment penalty until it is too late to avoid. They want to raise your cost of going elsewhere so that you will keep the loan at least a minimum amount of time. No matter whether they are a broker or an actual lender, this means they make more money when they do or sell your loan. A lot more money. A two year prepayment penalty is worth two to four points (point = percent of loan amount), more or less, on the secondary market. Longer penalties are more.

Now, the answer to the question. I know of precisely four ways to get out of paying a prepayment penalty, and three of them are trivially easy to describe.

The first is not accepting a prepayment penalty in the first place. No matter how bad your credit is, you do have this option. Your interest rate will be higher, or they will charge you more for the loan, but you won't have a prepayment penalty. In general, my experience has been that the higher loan rate is worth not having a prepayment penalty. If your loan amount is $300,000 and your rate is 6 percent, your prepayment penalty will be about $9000. Nor is it, in general, tax deductible if you have to pay it. In this case, if you had to accept a rate one full percent higher to avoid a three year prepayment penalty, you'd be breaking even.

The second is equally trivial. Wait to sell or refinance until the prepayment penalty has expired. Let's say your loan amount is that same $300,000 at that same six percent, and that you have a year and a half to go. In order to be worth refinancing, you would have to save two full percent on your new rate, and that's not counting anything you pay, costwise, to get the new loan.

The third way involves something not under the personal control of the borrower, in that it requires legal intervention for perceived legal wrongs done you, the borrower. It has happened in the past that courts have ordered prepayment penalties waived in such cases. It has also happened that companies have agreed to waive a prepayment penalty as part of a settlement. Both events, however, are quite rare, and require you to have gone through something bad enough to merit this. The one case I'm personally familiar with involved the lender playing games with payments that were being made on time to the point where they actually marked the people as being in default. I got them to a lawyer specialist and did exactly what that lawyer told me to, when he told me to, and nothing else. They went through something worse than purgatory at the hands of this lender and ended up paying thousands of dollars in attorney's fees, which they didn't recover, but at least they kept their home. Getting out of a prepayment penalty this way is a cure that's worse than the disease.

The fourth and final way to avoid a prepayment penalty is to refinance with the same company. Most (although not all) lenders will agree to swap the old prepayment penalty for a new one if you do your refinance with them. This does not mean that if you've got eighteen months left on a three year prepayment penalty, you've got eighteen months left on the penalty under the new loan. This means you've got a whole new three year prepayment penalty. It's like putting a problem off for another day, allowing it to fester. Far superior in most cases to just wait until the penalty is gone, because in the vast majority of all these cases your balance under the replacement loan will be significantly higher, and thus, the amount at risk due to a prepayment penalty will be more.

There you have them. The four ways to avoid paying a prepayment penalty. None of them is exactly wonderful, I know. But consider that the borrower agrees to the penalty when they accept the loan. It's part of the terms, and they do have alternative loans without prepayment penalties. It's just that most people jump to conclusions that this is a loan they want as soon as they hear the payment, and, if they're more cautious than average, the interest rate. Which is why you should be one of those who asks every potential loan provider about them, before you are stuck with one. I highly recommend asking the question, "And what is it without the prepayment penalty?" An ounce of prevention is worth many pounds of cure.

Now I get all sorts of questions about other ways to avoid pre-payment penalties. These range from good, such as "What if my spouse dies?" to understandable, such as "What if my employer transfers me?" to the ridiculous: "What if my cat has kittens?" What they have in common is that in none of those cases will the prepayment penalty be waived. Bottom line: Accepting a pre-payment penalty is a risk you decided to accept, and without the pre-payment penalty, you would not have gotten as good a rate, and your payments would have been higher. That is a concrete, certain benefit that you got. The price for it was accepting the pre-payment penalty, so don't be surprised or hurt or even gripe if the lender wants the money you agreed to pay in the event you did something that is under your control. You can always contact the lender and ask if they'll waive it under the circumstances, but the answer is going to be "no", and for the same reason that your auto insurance company won't pay the repair bill if you crash after your policy expires. You decided to assume the risk of pre-payment yourself, and you've been putting money in your pocket because of it. When that bill comes due, don't expect someone else to pay it for you when you have been putting money in your pocket because you said you would pay it if it happened. As I said above, an ounce of prevention is worth many pounds of cure.

Caveat Emptor

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Jeremy Hart Author Profile Page said:

Dan - congratulations on the award from Real Estate Undressed. I can see why Larry nominated you ... both this AND your post about reverse mortgages were very well-written and thorough. Nice job getting the information out there for folks!

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This page contains a single entry by Dan Melson published on May 16, 2014 7:00 AM.

Title Insurance, or Preventing Fifty Ways to Lose Your Money was the previous entry in this blog.

Fixing A Bad Mortgage Sale is the next entry in this blog.

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