The Pre-Payment Penalty: Gold mine or equity Quicksand?

Ninety-one year old Seattle woman’s mortgage mess as detailed by the NY Times.

“……That was the case for Gertrude Robertson, a 91-year-old widow and nurse’s aide living in Seattle who took out an adjustable-rate mortgage of $450,000 in January. Even at her age, Mrs. Robertson was earning $3,500 a month, largely by caring for another elderly woman. Then the woman died. Mrs. Robertson’s income was reduced to her monthly Social Security payment of $1,500. Meanwhile, her loan ballooned to $475,000. Unable to make the payments, Mrs. Robertson is listing her home for $510,000.”

Mrs. Robertson’s pre-payment penalty was $14,400.00. We have seen pre-payment penalties slightly higher than this paid out through our escrow office. I think there are many cases where consumers really don’t understand what they are signing. My wife Lynlee and I argued about this pretty robustly this morning. Lynlee contends that people should know what they are signing and if they are uncomfortable for any reason, they should not sign or at least consult an attorney or other party to help them understand the documents. She argues that if people get in trouble with loans they should not blame the loan officers or anyone else but themselves.

I don’t think Lynlee and I will agree on this issue. I think she is very naiive about why pre-payment penalties were so widely used. I think there are a lot more pressures to consumers and it leads them to make decisions that are not necessarily wise. How many Gertrude’s are out there? Thousands.

Update :  the New York Times Article was available through the link earlier this morning, but as of 9:50am it has been archived and you have to  log-in to access it.  Sorry about that.

42 thoughts on “The Pre-Payment Penalty: Gold mine or equity Quicksand?

  1. Loans with pre-payment penalties make sense for some people. They exist for a reason. But I do wonder how many people actually ask about them when they are getting a loan.

  2. Sounds like it was an option ARM with neg. am. Tim, the link to the NY story requires a password. 🙁 She probably didn’t understand the terms of her mortgage either.

    Sometimes a prepayment penalty can reduce a rate for a consumer…more often than not, it increases the revenue for the LO. With some subprime loans, they’re required and some may be cashed out (higher rate). Consumers should have the option of the higher rate or prepay.

    Just another reminder for mortgage-payers to drag out your notes and make sure you understand when and if your rate may adjust.

  3. TV ads running no closing cost loans, no truth in advertising. Try and tell someone that money is a commodity like gold, silver, or pork bellies and they will give you a funny look. Most of us buy payment and time. Loan officers should be called what they are, loan salesman and consumers given some idea how there are compensated. As consumers we are told to shop loans by comparing APR’s. Most loan officers have trouble giving an explanation other than saying it’s something the government makes us do. (the reg. z) Shopping APR’s 30 year fixed versus 30 year adjustable, APR comparison shopping does not work APR’s can be the same, consumers are buying payment. How many loan officers can brake out the yellow pad and pencil and show how to amortize a simple 30 year fixed rate loan, much less what happens when I make an extra payment towards principle every other month? My guess there are only a few people able to fully explain the true price of money covering negative amortization, the 11th district cost of funds, the LIBOR, prepayment penalties, service release premiums, yield spread premiums to another loan officer much less the average bear consumer. So in my opinion there are but a few fully informed money consumers and the majority will never be. I think the loan sales people should give the consumer the best case and worst case scenario and then let the consumer choose.

  4. Bob, I agree with you. It is the consumers choice and they should be informed. There are some that even once you do provide them with all the information to make a decision, they still want to make (what I would consider to be) the wrong choice.

  5. Many consumers are sold prepays like this:

    “Well if you want a lower payment or lower interest rate, you can always select a loan with a prepayment penalty. This shouldn’t be a problem if you plan on staying in the home for X years and you get the benefit of a lower interest rate. It’s your choice.”

    What is not told to the consumer, is that selling a loan with a prepay often yields a higher commission for the loan originator.

    As we all know in life, things happen. People get laid off, divorced, end up with medical bills or medical problems, businesses fail, and so forth. Then, homes must be sold…..and there’s that big prepayment penalty waiting for them.

    It’s a gamble.

    The consumer IS informed.

    It’s right there on their Truth-in-Lending form. They get one of these 3 days after application, and again in the closing room.

    You want more forms like this? Keep letting the government regulate mortgage lending. I can’t wait to see what they come up with next.

  6. Jillayne, the LO is not always getting a higher commission with the prepay (7 times out of 10, perhaps). I never tacked on a prepay. Life happens when you least expect it and your plans are changed.

    The prepays some clients have were set up with the loan (subprime) and the borrower would sometimes have the option of cashing out the prepay upfront. This was often too expensive in either rate or fee for the borrower. (not tacked on afterwards as extra LO dough).

    The consumer is not always informed. 🙁

    I’m dealing with a borrower right now he’s emailing me about a LO he’s still working with who has not provided a GFE or TIL….the borrower believes he’s closing on his home in two weeks! His real estate agent is telling him not to worry.

  7. Hi Rhonda,

    I believe you in regards to consumers not receiving a GFE (good faith estimate) and TIL (truth-in-lending form) since I’ve met LOs who have been originating for, say, 4 to 5 years now and have never been trained to send one to the consumer within 3 days of the date on the application per federal law.

    I’ve been told that subprime lenders paid more to LOs who sold 3 year prepays v. one year.

    In regards to the client you’re helping in comment 8, I wonder what the relationship is between the Realtor and the LO.

  8. Jillayne, I’m in a bit a disbelief that the buyer is staying with this LO after learning that their lender is not following the law.

    Lenders would price the prepays differently. First Franklin, for example, would often allow a 2 year fixed with 2 year prepay or 3 year fixed with a 3 year prepay at the same price/rate. I would give the borrower the choice. There would be no difference in payment to me. If the fixed period was the same and the AE (lender rep) would ask me what prepay term I wanted, I would ask for the shortest prepay to quote a client (if there’s no difference in rate/cost).

    It should be the clients choice.

  9. “In regards to the client you’re helping in comment 8, I wonder what the relationship is between the Realtor and the LO.”

    Jillanye, Jillayne in comment 8, Rhonda is referring to real estate agent. Of course a Realtor is bound by the Realtor Code of Ethics. It’s easy to just automatically refer to all real estate licensees as Realtors.

    I know, I know, it may seems like I’m slicing a fine hair here, but am I?

    I’m currently involved in a transaction with a real estate agent (who has admitted that he has a job and does real estate “on the side”) and it’s been very challenging. I’ve had problems with communication, procedures and contract timelines. I find myself calling the LO 2-3 times/week for my comfort and the comfort of my client.

    Of course, not all real estate agents are “bad”, and not all Realtors are perfect. There is, however, a difference in training and ethics between real estate agents and Realtors. Less than 20% of all real estate licensees get any kind of advanced education and work the real estate business as a full time professional occupation.

    It just kills me when buyers stick with LO’s or agents who don’t follow law, procedures or keep their interest at heart.

    As for the pre payment issue, yes some are legit. Some people just made more money for their LO.

  10. Jillayne noted that “things happen.” I agree with that fully.

    So far in my adult life I’ve lived places over 10 years, but I’ve never gone with a pre-pay just in case I need to move sooner than anticipated.

    Similarly, I would never go with an 80/20 because I’d be afraid of still owing money on the 20 after the 80 foreclosed. I always think in worst case scenarios, and I’d rather pay $XX.xx more per month than worry about losing my home and still owing $XX,XXX.xx on it!

  11. Tim, I’m so upset over seeing what happened to one of my past clients who I helped yesterday. He went thru another LO who suggested he refi (he recently divorced and wanted to remove his x’s name from the mortgage and title) into an option ARM; make the min. payment and invest the difference into an insurance fund. He did not realize until at signing that there was a 3 year prepay. He has 800 credit scores. If I could find the LO who did this to him…I’d probably punch her in the nose! 🙁

    This LO gave him a copy of “Missed Fortune” by Doug Andrews. Doug travels the LO and financial planner circuits to promote “equity harvesting” and reinvesting. There are points to his book that I agree with. However, I never believe that “one size fits all” with a financial strategy.

    Having an Option ARM kept this single Dad up at nights worrying what his rate was doing. Now we’re refinancing him back into a 30 year…and this ARM has eaten his equity not only be the deferred amortization…paying off the prepayment penalty of 6 months interest.

  12. 800 scores….and going into an Option Arm. Don’t even know what to day. It tires me to no end listening to the garbage rhetoric out there about all the “what if” scenarios in investing money etc. There are so FEW instances where a Neg. Am. loan makes financial sense. Er, let me rephrase that: there are very few cases for a BORROWER obtaining a neg. am. loan. that makes financial sense.

  13. Rhonda,


    Piranhas are in the river!

    Missed Fortune was very popular with a segment of the mortgage community to churn refis. As you said, there are some good points in the book, but I wasn’t comfortable with the way some LO were hawking the concept. I know of a couple of LOs that were holding monthly seminars and getting alot of refi bus from them convincing people to tap their equity.

    The thing that I know about pre-pays is that going in, 3 years seems like a short time especially when things are stable and going well. However ANYTHING can happen in that period of time…….and in fact we’re smack in a liquidity crisis.

    I’ts heartbreaking when a good client goes elsewhere, only to get burned. I’m sure you’ll do your best to repair as much damage as you can.

  14. Just last week, I had an interesting conversation with a CFP trying to convince me to set up “missed fortune” seminars. He was shocked that I was not interested…he was certain that I just “don’t get it”! He asked, “haven’t you read Missed Fortune?” “Have you seen Doug Andrew’s presentation?”

    I answered yes to both…however…I’m still not interested!

  15. BTW, I would love to work with some CFPs who are truly interested in helping clients get on the right track with their finances. Specifically, those who are just starting off and needing a plan. (sorry, I know this is off track with your post, Tim).

  16. Rhonda,

    It’s not off track. Do you want me to stop a meeting with friends over coffee and say, “Hey! Keep on topic!.” That’s why I love blogs. Other people chime in and it strikes a chord and then the topic changes or gets more color. Comments are never off track! LOL.

  17. Good times are intoxicating…..we never think they’ll end.

    The trouble with holding seminars around books like Missed Fortune, is that “professionals” read the book once, buy into it and start teaching it to others. Good CFP’s should know and understand the “cycles” of the economy and set up their clients in relation to their current wealth, age, and risk tolerance.

    What I can do for a client is to let them know, from my experience, if a house or property is a reasonable value for the market. I am very conservative with real estate investors. I talk them out of more properties than we make offers on and purchase. I’ve seen many investors with stars in their eyes want to make an offer, only to have me sloooooow them down to analyze the numbers. Many investments seem to make sense on the surface (especially flippers), but when everything, including the cost of sale, holding costs, and real improvement costs are analyzed, they don’t make any sense at all.

    Good LO’s are the same way with their clients. In this industry we all need to be the voice of reason with our clients. We need to lay out the risks objectively so that the client can make good decisions.

    Personally I’ve lost a lot of money taking short cuts in the sequence of financial success. Stability must be maintained at all times in every economy. People get in trouble when they attempt to straight from survival or stability to significance. Good solid foundations need to be in place. I’ve learned from past mistakes and have an appreciation for financial defensive positions.

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