January 11, 2010 in Mortgages

As the economy has dragged, many people are seeking to reduce their monthly financial obligations by paying off pesky second mortgages or refinancing their home loans to a lower interest rate. Some, however, are discovering an unpleasant extra cost as they make these changes: prepayment penalties.

Over the past few years, as housing prices skyrocketed and borrowers needed to find the cheapest possible way to finance their needs, banks used prepayment penalties as a way to lure buyers with low rates while locking in their profits. The idea was that the banks would lower their rates by a smidge — perhaps a quarter percent — but demand that buyers sign a contract to pay a penalty if they paid off their mortgage in a set period of time, usually between three and five years.

These contracts were structured to guarantee a certain amount of profit, says Ilyce Glink, publisher of ThinkGlink.com and the writer of a syndicated column called “Real Estate Matters.”

“The banks would do a risk calculation or a profit calculation, and the penalty itself was generally set between 2 percent and 4 percent of the loan,” Glink says.

For example, a penalty of 2 percent on a $200,000 mortgage would amount to $4,000.

While borrowers are required to sign disclosures about the penalties, they don’t often notice them in the stack of papers they’re required to sign at closing. And now, as they seek to pay off or refinance the loan, the penalties are coming back to haunt them. The fees may seem shady, but they’re not illegal.

“With a mortgage, you’ve entered into a legal contract, and most of the time, (the bank is) not going to want to go to the effort to renegotiate it,” says Clarky Davis, Debt Diva at CareOne Debt Relief Services in Raleigh, N.C.

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Even so, there are some ways to help reduce the financial pain of these costly penalties. Here are six steps to follow:

1. Check your contract. Be sure you have a prepayment penalty by sifting through your stack of mortgage papers. “It usually says ‘prepayment disclosure’ or ‘prepayment penalty disclosure,'” says Glink. “There are usually three or four documents you’ve had to initial to indicate that you’ve read them.”

2. Read the fine print. Some prepayment penalties are a single, fixed fee. Others are based on a sliding scale that decreases the longer you’ve held the loan. Try to get out at one year and you may pay 4 percent of the loan’s cost. After four years, you may pay just 1 percent. This can be the first place to try to lower your rate. If you’re close to hitting a reduced penalty threshold, consider waiting a month or two for a loan refinance or payoff.

3. Do the math. In some cases, the prepayment penalty is well worth the chance to move to a less risky, lower-interest loan. For example, if you pay $4,000 now but save $50,000 over 15 years by refinancing, it might be worth it. Similarly, the penalty might be justified just to get out of a balloon loan.

Still, in other cases, you may find that you need to lower the penalty before making your next move. Compare the options to determine your next move. A $4,000 prepayment penalty may be less palatable if you plan to move in a year or two, before you can reap savings from refinancing a loan. Or, you may simply not have the cash.

4. Get on the phone. To start negotiating, you’ll need to get the right person on the phone, and that probably isn’t the first person to pick up when you call the bank.

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“The first point of contact should be the loan officer,” says Davis. “But if you don’t have any luck here, escalate it to a manager. They generally have more pull and decision-making power.”

When you’re on the phone, ask what they can do for you. Though it’s unlikely that they’ll dismiss the penalty outright, you may get it reduced. For example, if you’ve been paying the mortgage for 22 months and a lower prepayment penalty kicks in at two years, they may trim the penalty even though you haven’t reached the two-year threshold.

5. Be polite. Keep in mind that no matter how awful your prepayment penalty is, you’ve signed a contract and the banks have the upper hand. Getting angry with a loan officer isn’t going to help your cause. “It never hurts to ask,” says Glink. “But ask nicely.”

6. Get it in writing. Make sure that you’re documenting everything: the names and titles of the people you’re talking to, the dates you called and any offer you’ve received. Ask to get the deal in writing. An offer over the phone is only as good as the paper it’s written on.

With foreclosures high and banks eager to improve profits, Glink says it’s more difficult than ever to convince bankers to waive prepayment penalties. Still, a potential reduction by thousands of dollars makes your investment of time useful.

“If (paying off a loan or refinancing) is something you’re thinking about, negotiating the prepayment penalty is definitely worth considering,” Glink says.

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