Understanding the Basis for Prepayment Penalties

[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.


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ARDELL is a Managing Broker with Better Properties METRO King County. ARDELL was named one of the Most Influential Real Estate Bloggers in the U.S. by Inman News and has 33+ years experience in Real Estate up and down both Coasts, representing both buyers and sellers of homes in Seattle and on The Eastside. email: ardelld@gmail.com cell: 206-910-1000

50 thoughts on “Understanding the Basis for Prepayment Penalties

  1. Excellent explanation Ardell. Prepayment penalties are one of the most misunderstood and misused tools in the lending industry. Too many people avoid them and end up in higher rates when they could have benefited from a rate reduction by using a prepayment penalty and too many people signed on for prepayment penalties either (a) without knowing they had one or (b) with terms that were too stringent or long in terms of expiration.

    When a borrower is considering a prepayment penalty they need to have an excellent idea of how their life is going to look for the next few years. I know far too many people who thought they would be in a home for 5 years decide to move after 18 months and are upset that they signed on for a 3 year prepayment penalty.

    I am all for prepayment penalties in the same way I am for exotic loans – they are only tools that should be used in the proper circumstances with a full understanding of the ramifications of choosing those options. Without that understanding they can be ugly traps and surprises to the unwitting borrower.

    One place where prepayment penalties really become a problem is when a subprime borrower over-extends themselves on a loan and then tries to refinance at a later date to help relieve some of the payment burden their first loan got them in. Usually this is within the first year of the new mortgage when they are still 10-12 months away from the expiration of their prepayment penalty.

  2. Morgan,

    I think it’s a shame that people with excellent credentials are worried about these things. I don’t think I’ve had more than one or two clients who had pre-payment penalties in 17 years. In fact, I can only think of one and it was perfectly justifiable. The borrower was very lucky the loan went through at all, and very grateful that it did. It’s a shame so many are worrying so much.

  3. Ardell, I like how you’ve presented this topic. I have done several loans with prepays..most of those were 80/20s and so borrowers would not have any equity to afford selling anyhow for a couple years.
    I’m still opposed to prepays (unless they are required by the lender, typically subprime) since a borrower never knows when “life” is going to happen. Then, wammo, 6 months interest on your mortgage balance, please.
    Whenever I’ve had more than one option for a client, I present both and let them know they can have xy loan with a prepay at a lower rate and save this much over this much time or uv loan without the prepay (freedom to sale or move w/o penalty) at a slightly higher rate. It should be the clients choice when an option is available.

  4. Brian, Morgan and Rhonda,

    From what I’m hearing in the comments, the example should say, well you can either pay for 8.25% for the entire length of the loan with no prepayment penalty OR you can pay me 8% and an extra $200 only IF you pay it early.

    What’s the spread from prepayment penalty to no prepayment penalty? An 1/8? 1/4?

    Actually, the only one I know who took the prepayment penalty (1 year) was me 🙂 It was the cost of getting my own house after my divorce, and I was very grateful to the lender for having taken a chance on me as a “single woman” after the divorce.

    After buying houses as a couple for 20 years, it is sometimes hard to maintain as a single person. That’s my “rent vs. buy” scenario. I just didn’t feel as good about myself as a single renter vs. a single homeowner. Maybe I needed to prove to myself that I could do it alone, after having been married for 20 years. Whatever the reason, I’m glad I did, and have enjoyed my home immensely more than I did as a “renter” temporarily after the divorce.

    Self esteem is not a small reason. Maybe the most important one.

  5. No offense Brian,

    But I used a street example because my definition of “hard money lender” is Loan Shark. When I was a kid we had lots of “hard money lenders” in my neighborhood 🙂 None of the Italian immigrants qualified for loans or mortgages. The only difference was what happened if you didn’t pay, but otherwise, pretty much the same.

    I seriously can’t imagine why someone would sell their house for less than 70% of fair market value. Sounds like a popped up appraisal to me. Why would anyone leave 30% of the home’s value “on the table” without a “gun to their head”?

    The investor market is littered with people who THOUGHT they were getting a property for far less than fair market value, only to find that they didn’t when they tried to flip it. I think it’s a dangerous game. I’d say only 1 in 20 people who believe they “got a steal” really did. And I’m being generous with those odds.

  6. Hey Ardell,

    It would be nice to hear from some of our mortgage officers as to what criteria will trigger a pre-payment penalty being included in a loan. My perception, and it may be inaccurate, is that banks frequently include these loan terms, and the criteria to include them in a loan seems pretty arbitrary…am I right on this?

    You didn’t really highlight how limiting a term like this can subsequentlty be for a borrower…particularly since some of these pre-payment penalties are running up to 5 years, which is a long time this day and age (has anyone seen any longer times?). For example, consider how the borrower/consumer is hurt if any of these items occur during the pre-payment period: (1) Interest rates subesquently drop below the loan’s rate…can the borrower refi to take advantage of this, and come out ahead? (2) The loan is an ARM, and adjusts upwards…can the borrower refi to avoid this and come out ahead? (3) Borrower wants/needs to sell the house…can the seller/borrower do this and come out ahead (if there isn’t much equity, this can be a serious problem)?

    Obviously, facts & circumstances are critical here as to what may/may not happen; but these things need to be fully explained to borrowers (including the “bad” stuff that lenders don’t always like to talk about). Banks put these terms in for the bank’s benefit, NOT the borrowers.

  7. To me Joe, it’s not so darned complicated.

    It’s like the reverse of buying a CD at the Bank. I use that analogy as most conumers “get” that.

    You go to a bank and they pay you more interest, IF they can have a guarantee that you won’t pull the money before they expect you to…ie at end of period.

    A five year CD usually pays more than a 6 month CD. Everyone knows there is a penalty if they cash in their 5 year CD in 3 years.

    So a prepayment penalty is the reverse. Lender says I’ll give you a LOWER rate IF you promise not to pull the rug out from under us.

    Guaranteeing the term of “not less than” 1 or 2 or 5 years to the lender, gives you a better interest rate.

    It’s not “arbitrary”…it’s an option. Not much different than a bond priced at par or above par or below par. Interest and guarantees of interest for given timeframes, is not a foreign or “arbitrary” concept. Anyone who understands money, understands the value of knowing you will be getting that interest for a “given” period of time.

    Same as people who put all their eggs in the wrong 401K basket, and then needing to pay a penalty upon early withdrawal. Only difference is, it is a lender and not a bank or mutual fund.

    I was willing to take the risk of ONE year in exchange for a lower rate. I won the bet 🙂

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  9. Hi Ardell,

    I don’t think the concept is difficult to understand either. My clients have seem to understand what’s at stake with a pre-payment penalties. What I meant by “arbitrary” was that banks seem inconsistent in their use of pre-payment penalties. I’ve had several situations with clients who had “fair” credit ratings get banks to remove these terms from their loans; yet other times I’ve had clients with “good” credit ratings have banks insist a pre-payment penalty must stay in the loan. Obviously, the banks are using some criteria to make this determination; but what is it?

    I’m hoping some of our RCG loan officers may give me some tangible insight into what triggers the inclusion of a pre-payment penalty into a loan? Obviously, credit score, debt-to-income ratio, amount of loan, length of loan, and other “typical” loan criteria affect this; but I’ve always suspected there’s more to this than meets the eye. For example, what’s happening in the secondary loan market, seems to also have an impact…other factors too, perhaps???

    I’d like to be able to explain this a little better to my clients, so that’s why I’m hoping our RCG loan officers may chime in here!! 🙂

  10. Joe, to my knowledge prepayment penalties may show up under the following possible circumstances:

    1) Lender required due to being a subprime loan–not optional or very expensive to “cash out”
    2) Lender required due to investment property (some added a 1 year–not optional to cash out–prepay to prevent flipping)
    3) Adding a prepay penalty may provide a lower rate to a non-subprime loan (a paper). THIS SHOULD BE THE BUYERS OPTIONS
    4) Adding a prepay penalty may pad the LOs pockets if the loan is non-subprime (a paper). This would be if ex. 3 above happens and the buyer did not have the choice of the lower loan.

    It should be the borrower’s choice. And, when they don’t have the choice of whether or not to have a prepay (subprime or alt-a product); then they should know their options… of waiting or buying now.

  11. “I seriously can’t imagine why someone would sell their house for less than 70% of fair market value.”


    “But I used a street example because my definition of “hard money lender

  12. Rhonda, I thought the “Joe” Brian referred to was the “Joe” in Ardell’s hypothetical, not me personally? At least that’s what I assumed.

  13. LOL! JOE!

    I seriously have used Joe long before you came on the scene. It’s kind of like “Joe Blow”. Sorry.

    Rhonda, Joe is like any old Tom, Dick or Harry, John Doe, Joe Blow, not the highly respected attorney of mention 🙂

    Next time I’ll use “Vinny”.

  14. Ardell,

    I figured “Joe” was a character you’d used previously. When you have a generic name like, “Joe”, you get used to that. BTW, you’re more than welcome to continue using “Joe” in your hypotheticals as far as I’m concerned.

    Hmmm…maybe your “Joe” could be your tall, dark, mild-mannered, super hero sort of character…always doing great stuff like helping old ladies across the street, saving a bus load of orphans from crashing off a bridge that’s been washed out in a bad storm, or even…drum roll please…helping FSBO people straighten out their deals…woohoo!! LOL 🙂

    Hmmm…maybe he also needs a love interest…. LOL 🙂

  15. Ardell,

    Actually, maybe I should start using my own “Joe” character…how about “FSBO Joe”…it rhymes, and is kinda’ catchy!! Hmm…now to come up with story lines for him…could be fun as well as educational…I’ll have to work on that. 🙂

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