Prepayment penalties, balloon payments increase risk
By Holden Lewis • Bankrate.com

Some activities invite heartbreak and loss: driving without a seat belt, marrying someone after one date, experimenting with heroin. Add another to the list: getting a home loan with a prepayment penalty or balloon payment.

People who refinance their mortgages with loans containing prepayment penalties or balloon payments are more likely to undergo foreclosure, according to a study by researchers at the University of North Carolina.

Prepayment penalties and balloon payments are most often found in subprime mortgages (higher-rate home loans for borrowers with flawed credit). It's common sense that these loans have higher foreclosure rates, and this research backs it up with hard evidence, says one of the authors.

"Our study for the first time really definitively gives you the order of magnitude of the additional risk of foreclosure that are posed by these terms," says Michael Stegman, director of the Center for Community Capitalism at The University of North Carolina at Chapel Hill.

The study, by Stegman, Walter Davis and Robert Quercia, estimates that a prepayment penalty increases foreclosure risk by about 20 percent, after compensating for factors such as income and credit score.

Mortgages with balloon payments were 46 percent more likely to go to foreclosure than loans without balloon payment provisions to comparable borrowers, according to the study of more than 122,000 subprime refinance mortgages originated in 1999.

Prepayment penalties punish borrowers for refinancing, and balloon payments punish borrowers for not refinancing. A prepayment penalty is levied on the borrower for paying off the mortgage early -- whether by refinancing the loan or selling the house. A balloon loan requires the outstanding balance to be paid in a lump sum after a set period.

Almost 72 percent of the mortgages in the study had prepayment penalties, usually lasting three or more years. About 14 percent of the mortgages had balloon provisions. About 80 percent of balloon loans have prepayment penalties, Stegman says.

In a theoretical worst-case scenario, the two loan provisions could bump into each other: A borrower could be forced to pay a prepayment penalty for refinancing within five years of getting the loan and could be forced to make a balloon payment of the entire balance at the mortgage's five-year anniversary. Few, if any, lenders would be that diabolical. But federal laws wouldn't prohibit it.

In the study, a common prepayment penalty was a fee of six months' interest on the outstanding balance. That means that someone who borrowed $100,000 at 12 percent interest, and who then sold the home a year later, would have to pay a penalty of almost $6,000 for paying off the loan early.

Without a prepayment penalty, a homeowner with an unaffordable mortgage can get out of financial trouble by refinancing the loan or selling the house. A prepayment penalty can trap a borrower into keeping the unaffordable loan past the point of no return into delinquency, foreclosure and eviction.