[photopress:fear.jpg,thumb,alignright]In my last two closings, the buyers were fearful of maybe having a prepayment penalty. A lot of fear has been spreading around about sub-prime mortgages and pre-payment penalties, to the point where everyone is catching the fear bug.
I thought I’d try to explain what sub-prime mortgages and pre-payment penalties are about, in a way that most people can follow, to help alleviate some of this fear.
Say you go to your friend Joe and ask him to lend you $20,000. You tell him you are more than happy to pay him interest. Joe says, well…I was going to go buy a two year CD with that money. The bank is going to give me 5% interest. You say, no problem, I’ll give you 5% interest. Joe says, well no offense, but seriously, I trust the bank a whole lot more to pay me that 5%, and to give me my $20,000 back, when the CD comes due in two years.
You think about it. You know he’s right. There is more risk for Joe if he lends you the money than if he just bought a CD. More risk equals higher return. So you say, look Joe, I’m really in a jam here. Joe says no kidding. Why would someone lend you money? You told Sam you’d pay him next week and it took two months. (equivalent to low credit score-didn’t pay others on time or “as agreed) So you offer him 6%. He says an extra 1% isn’t really worth the risk on $20,000. An extra $400 at the end of two years isn’t worth me sweating that you might not pay me. So you ask him at what point might he consider lending you that $20,000. He says given the risk I’m taking on you (with a low credit ranking) I’d give you the money if it was 8% a year. That’s $600 a year more than the bank would give me and $1,200 more over two years. OK. at 8% I’d lend it to you.
That is why there is a higher rate and why it is called “sub-prime”. “A” paper” or the “going rate” would be the 5% in that example, and the “sub-prime” rate is the rate someone is willing to lend at to a lower credit worthy borrower, in this case 8%.
Now Joe says, but hey. You have to guarantee I’m going to get that 8% for two years. I don’t want to stick my neck out and only get $100 bucks for my trouble and worry. You say, but what if I have the money to pay you back in 3 or 6 months. Joe says, NO WAY! I have to sweat it out for six months thinking maybe I’ll never get my money back and all I get is 3 months worth of interest at 8% for my trouble? That’s only $150 more than I would have made at the bank, and the bank’s rate might go down in three months. No. If I’m going to lend you that $20,000 for TWO years, I want 8% interest for TWO years. No fair paying it off early. I don’t want the aggravation for a measly $150 benefit.
I want to be able to count on that 8% for at least two years IF I’m gonna take a chance on you. You say, how about, if I pay you in 1 year, I give you 8% plus an extra $200 bucks for your trouble. I think I’m going to be paying you 8% for AT LEAST 2 years. BUT, if I do pay you early, I’ll give you a little more than the 8%, say $200 dollars. (the $200 is the prepayment penalty).
So Joe lends you $20,000 at 8% interest with a $200 prepayment penalty if he doesn’t get 8% for a full two years.
People talk about sub-prime and pre-payment penalties like they are something bad. In fact they are giving someone a chance who maybe has a hard time convincing people that he’s “a safe bet”.
If you have a credit score of 700 or more, you really shouldn’t be worried about pre-payment penalties and sub-prime loans. The only time they can creep in to people with high credit ratings is when you are buying more than you can really afford or your other debts are higher than they should be for you to spend that amount for the house. So make sure you know your ratios. Your “front end” AND your “back end”. But that’s another story for another day.