Prepayment penalties, balloon payments increase foreclosure
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
in 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.
|Prepayment penalty term
||In foreclosure at least
|No prepayment penalty
|Penalty less than three years
|Penalty three years or more
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
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.
Prepayment penalties and balloon payments are abusive
and predatory, say Stegman and fellow critics of subprime loans.
They are costly, are applied unfairly, lead to foreclosures, and
don't even give borrowers a break on interest rates, says Keith
Ernst, senior policy counsel for the Center for Responsible Lending
in Durham, N.C.
That last assertion is disputed by the subprime lending
industry. Ameriquest, the biggest subprime lender, has a set of
best practices that pledges "to show borrowers how they can reduce
their rates through discount points and prepayment options."
New Century Financial Corp., the second-biggest subprime
mortgage lender, says that it does not make or buy loans with balloon
payments. As for prepayment penalties, New Century says it offers
loans with and without them: "When a borrower opts for a loan with
a prepayment charge, the borrower benefits from a lower interest
rate or pays lower upfront fees," its set of best practices says.
Nevertheless, Ernst, in a report issued this month
by the Center for Responsible Lending, concludes that on subprime
refinance loans, there was no significant difference in rates between
mortgages with prepayment penalties and those without, "as borrowers
receive the burdens of penalties without the compensating benefits."
"Once the penalty is in place," Ernst adds, "the borrower's
ability to build wealth is significantly hampered since the borrower
either continues to pay excess interest or gives up accumulated
home equity to get a better loan."
The University of North Carolina study says that,
of the borrowers who got loans with prepayment penalties, 37 percent
ended up paying the fees, either because they refinanced or they
sold their homes. "These penalties, if fully enforced, generated
hundreds of millions of dollars for lenders at the expense of borrower
equity," the report says.
The report was released at a news conference attended
by Stegman, Ernst and Nina Simon, an attorney for the AARP Foundation
who sues predatory lenders. A reporter invited the three to identify
egregious lenders, but they declined to. Ernst said that 70 to 80
percent of subprime mortgages have prepayment penalties, so the
whole industry is culpable.
The industry's trade association, the National Home
Equity Mortgage Association, or NHEMA, had no immediate response
to the report.
Stegman, Ernst and Simon praise states (such as North
Carolina, Massachusetts and New Jersey) that have anti-predatory
lending laws that ban practices such as excessive prepayment penalties
or balloon loans. They contend that subprime mortgages are just
as available in these states as in others -- but with less onerous
NHEMA counters with its own studies, including one
released last year that concluded that subprime lending in New Jersey
"dropped significantly" after that state's anti-predatory lending
law went into effect. That study said it was more difficult to borrow
in New Jersey afterward -- borrowers needed higher incomes and higher
credit scores to qualify for subprime mortgages.
Stegman and his co-authors scrutinized a national
database of subprime, refinanced mortgages that were originated
in 1999. They tracked the loans to the end of 2003 and analyzed
them statistically. They chose to look at refinanced mortgages because
such loans were more likely to have prepayment penalties and balloon
payments than purchase mortgages. About 73 percent of the borrowers
had done "cash-out" refinancing -- they had refinanced for than
they originally owed, and pocketed the difference.