When the housing market crashed in the early 2000s, new mortgage rules were introduced to prevent a similar crisis in the future.
The Dodd-Frank Act gave us both the Affordable Care Act and the Qualified Mortgage Act (ATR/QM Act).
The ATR requires creditors “to make a reasonable, good-faith judgment of the consumer’s ability to repay the home loan on its terms.”
Although the QM law gives lenders “certain protections from debt” if they establish debts that meet that definition.
When lenders offer loans that don’t include risk factors such as interest only, negative amortization, or balloon payments, they get some protection if the loan goes bad.
This has resulted in many loans being QM compliant, and so-called non-QM loans with such illegal features becoming more difficult.
Another common feature in the early 2000s mortgage market that was not legalized, but became more restrictive, was the prepayment penalty.
Given the risk of prepayments today, perhaps they could be re-introduced responsibly as a savings option for homeowners.
Most Loans Used to Have Prepayment Penalties
In the early 2000s, it was very common to see prepayment penalties attached to home loans.
As the name suggests, homeowners were penalized if they paid off their mortgage early.
In the case of hard prepayments, they could not refinance the mortgage or even sell the property for a certain period of time, usually three years.
In the case of soft advances, they could not repay the money, but they could sell freely whenever they wished without penalty.
This protected lenders from early payments, and apparently allowed them to offer a lower loan rate to the buyer.
After all, there were certain guarantees that the borrower could keep the loan for a short period of time to avoid paying the penalty.
Generally speaking, the penalty was often steep, like 80% interest for six months.
For example, a $400,000 loan at 4.5% would result in a profit of about $9,000 in six months, so 80% of that would be $7,200.
To avoid this steep penalty, homeowners may hold on to the loan until they are allowed to refinance/sell without foreclosure.
The problem was that prepayments were often attached to adjustable-rate loans, some of which changed as quickly as six months after they were originated.
So you can have a situation where the home owner’s mortgage resets too high and they are stuck on the mortgage.
Long story short, lenders have abused the prepayment penalty and made it a non-starter problem after the mortgage.
New Rules for Prepayment Penalties
Today, it is still possible for banks and mortgage lenders to attach prepayment penalties to mortgages, but there are stricter rules in place.
As such, many lenders don’t bother using them. First, the loans must be Qualified Mortgages (QMs). So no risk factors are allowed.
In addition, the loan must also be a fixed rate loan (no ARMs allowed) and cannot be a prime rate loan (1.5 percent or more of the Average Prime Offer Rate).
The new rules also limit prepayments in the first three years of the loan, and limit the amount to two percent of the outstanding balance prepaid during the first two years.
Or one percent of the remaining prepaid balance in the third year of the loan.
Finally, the lender should also present the borrower with an alternative loan with no prepayment penalty so that he can compare his options.
After all, if the difference was small, the buyer might not want that down payment attached to their loan to ensure maximum flexibility.
Simply put, this laundry list of rules has made prepayment penalties a thing of the past.
But now that mortgage rates have rebounded from their record lows, and may be making decent returns, there may be an argument for bringing them back, properly.
Can a Prepayment Penalty Save Money for Borrowers Today?
Recently, the mortgage rate spread has been a big talking point because it has become so wide.
Historically, they have hovered around 170 basis points above the 10-year bond yield. So if you wanted to track mortgage rates, you could add the current 10-year yield and 1.70%.
For example, today’s yield of about 4.20 added to 1.70% would equal a 30-year yield of about 6%.
But due to recent volatility and uncertainty in the mortgage world, spreads are almost 100 basis points (bps) higher.
In other words, that 6% rate could be closer to 7%, to limit things like prepayments.
Much of that comes down to prepayment risk, as seen in the chart above from Rick Palacios Jr., Director of Research at John Burns Consulting.
Long story short, many homeowners (as well as lenders and MBS investors) expect rates to go down, despite the fact that they are currently very high.
This means that the loans that are started today will not last long and paying them off will not make sense if they are paid off after a few months.
To mitigate this concern, lenders may also introduce prepayment penalties and lower their loan amounts in the process. Maybe that rate would be 6.5% instead of 7%.
Ultimately, the borrower will get a lower interest rate and that will reduce the chances of paying off early.
Both because of the penalty and because they will have a lower interest rate, making repayments less likely to lower rates further.
Of course, they will have to be used responsibly, and maybe only be given for the first year of the loan, maybe two, to avoid becoming a trap for homeowners again.
But this could be one way to give lenders and MBS investors some guarantees and borrowers a little better value.
Before creating this site, I worked as an account manager for a real estate broker in Los Angeles. My experiences in the early 2000s inspired me to start writing about mortgages 18 years ago to help prospective (and existing) home buyers better navigate the mortgage process. Follow me on Twitter for the latest.
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