Prepayment Penalties & Indexes
This article deals with some rarely discussed mortgage details that can have a major financial impact if you’re not careful. For starters, there’s Prepayment Penalties. These penalties can cost you a bundle and they’re often overlooked during the origination of the loan as well as the signing. Many mortgage brokers know perfectly well the program they’re putting you in has a Prepayment Penalty and they avoid the topic as much as possible. So a lot of people have penalties and don’t even realize it. This situation just happened to a client of mine who wants to refinance OUT of an adjustable rate mortgage and INTO a fixed program.
We sat down to review the options and I asked to review her existing mortgage Note and that’s when we discovered the penalty. She had no idea. That Prepayment Penalty would cost her almost $14K if we went ahead with the refinance. Now, in some circumstances, it may still be worthwhile doing the transaction. For example, if rates were rising quickly or if fixed interest rates took an unexpected dip, presenting an unusual opportunity, it might still make sense to do the deal.
But in her situation, the breakeven would be too long to justify the added costs. I recommended she wait until her Prepayment Penalty expires next November and we’ll do the refinance then. Now, let me guarantee you that most mortgage brokers would NEVER have that conversation with you. Most would only stress the financial risks of keeping the existing mortgage and push you to begin the refinance as soon as possible. That’s why it’s so important to find someone who’s got your best interests in mind. Let’s take a closer look at these penalties. Fact is, lenders don’t make any money if you get a new mortgage and then refinance out of it six months later. Lenders want you to stick around for a while. And they also know that some types of borrowers tend to refinance much sooner than others, so here’s the basic structure. A-paper loans don’t have Prepayment Penalties.
It’s not possible. They don’t exist. So if you’re getting into an A-paper loan, you don’t have to worry about any Prepayment Penalties. And if you HAVE a Prepayment Penalty, by the way, you can rest assured you’re NOT in an A-paper program. Alt-A programs usually have OPTIONAL Prepayment Penalties. As always, these are generalizations and I’m sure exceptions exist but most Alt-A programs I’ve worked with have optional Prepayment Penalties. So that means you could CHOOSE to have one and there might be an advantage in doing so. The lender might give you a slightly better rate if you accept the penalty. In some cases, I’ve seen rate improvements as high as ¼% for accepting a 3-year Prepayment Penalty. That’s pretty impressive and we’ll talk about that decision in a minute.
Subprime programs come standard with Prepayment Penalties. They’re there whether you like it or not. And if you want to ‘buy it out’, it’ll cost you handsomely. It’s expensive. In fact, it’s almost like paying the penalty up front. So if you’re getting into a Subprime program, you can expect a Prepayment Penalty in your mortgage. And if you buy it out, your interest rate will be significantly higher, sometimes 1% or even 1.5% higher. That’s a big difference. So, what will it actually cost you? Well, most Prepayment Penalties last for 2 or 3 years (some only last for 1 year but most last for 2 or 3).
If you have to pay it, it’s usually calculated as 6 months worth of interest on your loan balance. So you can calculate this for your own mortgage. Just take your loan balance, say $400K and multiply it by your interest rate, say 6%. These are obviously just round numbers. But if you took those numbers - $400K times 6% - you’d get $24K. That’s the interest you would pay for a FULL year – 12 months. Take that number and divide it by 2 to get the amount you’d pay for just 6 months and you get $12K. Well, that’s it. That’s the Prepayment Penalty you’d pay on a $400K mortgage at 6%.