It seems with the latest mortgage guidelines that prepayment penalties would be a thing of the past, but in reality, they are still around. Granted, banks have to jump through several different hoops before being able to place a prepayment penalty on your loan, but it is still a possibility. In order to ensure that your loan does or does not have a penalty, you need to read your closing documents very closely. Typically there are several disclosures included in the packet that will demonstrate that you have a penalty. Make sure to ask as many questions as necessary before signing any paperwork. Your lender will go through plenty of his own work to be able to charge you with the penalty as there are many requirements to meet before it can be applied.
Prepayment Penalty Guidelines
Today, loans must meet a large variety of requirements in order for the lender to not be held liable for the loan. In the event that a lender provides a loan that they did not do their due diligence on and the borrower defaults, the lender may be liable to purchase the loan back from the investor or be able to be sued by the borrower. This regulation was put into place in order to protect investors and borrowers alike. The same is true for the prepayment penalty. Lenders can no longer just slap a penalty on a loan in order to keep their profits up by preventing borrowers from paying it off or refinancing into a lower rate in the near future. They have to meet the following requirements:
- The loan must be a fixed rate loan. Any loan with an adjusting rate (ARM) cannot have a prepayment penalty. Because these loans have interest rates that can go up within a few short years, borrowers need to the ability to refinance out of them in order to ensure that they can still afford the loan. A fixed rate loan offers a little more predictability; borrowers are not guessing what their future payment will be which enables them to plan for the future, ensuring that they can afford their payments.
- The loan must fall under the Qualified Mortgage guidelines. These guidelines are put in place to protect the borrower, ensuring that no borrower is provided a loan that the lender does not think they can afford nor does it allow the distribution of risky loans. The risky loans that QM guidelines prevent include interest only loans; loans with terms longer than 30 years; or negative amortization. These guidelines make it harder for self-employed borrowers to obtain a loan as well because they need to be able to document their income for at least two years with adequate sources in order to qualify.
- The loan’s pricing cannot be considered excessive. The benchmark for excessive loan pricing is based off of the Average Offer Prime Rate. This rate is figured based on the average interest rate plus any applicable fees that are offered to borrowers with excellent qualifications. If the loan’s rate exceeds this benchmark, it cannot have a prepayment penalty.
- The prepayment penalty cannot be longer than 3 years. The 3 year benchmark begins based on the requirements in your state. Some states say that it starts upon signing of the closing documents while others state that it begins when the lender provides a loan commitment to the borrower.
- The prepayment penalty cannot be more than 2% of the amount of the loan for the first two years of the loan.
- The prepayment penalty cannot be more than 1% of the outstanding loan amount during the third year of the loan.
- The lender must provide an alternative to the loan with the prepayment penalty. The lender must disclose the differences in the loan (namely the interest rate or fees) and let the borrower decide between the two loans rather than making him feel forced into the loan with the penalty.
Prepayment Penalty Disclosures
Just like everything else in regards to mortgages today, you must have proper disclosure regarding your prepayment penalty. The servicer is required to remind you of this penalty in several places in order to ensure that you are well aware of the penalty and what it means for you. The three places it must be displayed include:
- On your billing statements
- On your monthly payment coupons
- On any notices you receive regarding your mortgage
Determining if the Prepayment Penalty is Worth It
Once you know your options regarding a loan with a prepayment penalty and one without, you need to make a decision. This will not be an easy one as you will likely see a lower interest rate and therefore lower monthly payment and be immediately interested in the loan with the penalty. However, looking at the larger picture, you might see that the loan without the penalty is the better choice for you. It depends on certain circumstances including:
- How long you plan on staying in the home (the longer you stay the better a prepayment penalty becomes)
- If you plan on refinancing in the near future (maybe you are taking a higher than normal interest rate right now because you have slightly delinquent credit but are working to improve it)
- How much you put down on the home (The less you put down, the more PMI you will pay and the more your monthly costs will be. If you plan on refinancing out of PMI or lowering your interest rate in the future to make your payment more affordable, the loan without the penalty is the better choice)
Everyone will have their own deciding factors when it comes to the prepayment penalty. Always discuss your options with your lender and determine which would work best for you. In addition, always make sure you read the fine print and fully understand the penalty before signing anything to ensure that you are protected in the future.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.