Prepayment Penalties, Balloon
Payments Increase Foreclosure Risk
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 once
|
|
No prepayment penalty |
15.3 percent
|
|
Penalty less than three years |
19.9 percent
|
|
Penalty three years or more |
23.6 percent
|
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.
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 terms.
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 more than
they originally owed, and pocketed the difference.
[Article
by Holden Lewis -- Posted January 27, 2005 -- http://www.bankrate.com/brm/news/mortgages/20050127a1.asp]
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