Thursday, April 10, 2008

Stripped Bare - Beneath the Feel Good Veneer of Subprime Lending

Chapter 12 - Prepayment Penalty Box

The majority of subprime loans, eighty percent (80%) or more, written over the years were written with prepayment penalty clauses.  In the prime lending industry, less than two percent (2%) of mortgages written were/are subject to prepayment penalties.  During my over ten years of writing prime, “A” paper, mortgages, I never once encountered a prime loan with a prepayment penalty.

These prepayment penalty clauses required borrowers who had taken out a subprime loan to pay a penalty fee of anywhere from one percent (1%) to five percent (5%) of the mortgage amount if they paid off, refinanced, their subprime mortgage early.  There were also prepayment penalty clauses written which required up to six (6) months of interest be paid to the lender if a subprime loan was paid off early.  Prepayment penalty clauses of this type were the most onerous for subprime borrowers.  On a mortgage amount of $100,000.00, at an interest rate of eight percent (8%), the prepayment penalty for early payoff would amount to almost four thousand dollars ($4,000.00).

Prepayment penalties could run anywhere from one (1) year to five (5) years on subprime loans.  Since the majority of prepayment penalty terms ran concurrently with the type of subprime loan written for borrowers; i.e. if a subprime borrower financed with a 2/28 adjustable rate mortgage (ARM), the prepayment penalty was in effect for two (2) years, if the loan was a 3/27 ARM, the prepayment penalty was in effect for three (3) years; most subprime borrowers who desired to refinance out of their current subprime ARM, prior to their payment adjusting, and payments in most cases would adjust upward, paid a prepayment penalty.

Prepayment penalties could also be either “hard” or “soft,” though most prepayment penalties were hard.  “Soft” prepayment penalties were associated with those subprime loans which were being paid off due to a refinance.  If the property was being sold by the borrower, no prepayment penalty would be assessed.  “Hard” prepayment penalties were due whether the mortgage loan on a property was being paid off due to the sale of the property, or a refinance.  Needless to say, the majority of subprime loans carried hard prepayment penalties.

Prepayment penalties were assessed on subprime loans as a disincentive to borrowers to refinance.  This of course was somewhat contrary to the sales pitch most subprime borrowers heard from subprime lenders, that pitch being the “this loan is just a short term loan to get your credit back on track to be a prime borrower and we will refinance you again in twelve (12) months.” Additionally, subprime prepayment penalties were assessed as an incentive to the secondary market; think institutions such as Bear Stearns; to purchase large blocks, known as mortgage backed securities, of subprime mortgages.  Another reason prepayment penalties were assessed on subprime loans was the penalties were a means of offsetting the loss of interest revenue servicers incurred from the oh so frequent refinancing of subprime loans.

Subprime borrowers who were refinancing out of one subprime loan and into another subprime loan, prior to the expiration of the prepayment penalty term on their existing mortgage, frequently asked for prepayment penalties to be waived.  Rarely would such a request be granted.  Even when a subprime borrower was refinancing a current subprime loan within thirty (30) to sixty (60) days of the expiration the prepayment penalty, rarely would the subprime lender waive the penalty.  Even if the subprime borrower was refinancing their current subprime loan, with their current subprime lender, chances of the prepayment penalty being waived by the subprime lender were virtually nil.

Though subprime loan prepayment penalties were disclosed to borrowers in written documents, legally stipulated disclosures, they were infrequently discussed verbally.  When prepayment penalties were discussed verbally with subprime borrowers, and usually only because the borrowers inquired about any prepayment penalty, it was not uncommon to hear subprime lending account executives informing prospective borrowers that the prepayment penalty was of minimal concern, and then quickly change the subject over to how much cash the borrower would receive at the closing, or, how much money they would be saving each month if they moved ahead with the refinance.

In situations where prepayment penalties had not been verbally discussed with subprime borrowers, it was not unusual for borrowers to contact the subprime lender during the actual loan closing to inquire about the prepayment penalty.  This occurred because the borrowers were once again required to sign another document stipulating they were aware that the loan they were currently taking out was subject to a prepayment penalty during the closing process.  In cases where this happened, the objection to the penalty was handled by informing the borrower that the penalty had been disclosed to them via the stack of documents they had received, and signed, acknowledging receipt of said documents and their contents, when they initially applied for the loan.  If borrowers continued putting up a fuss about the prepayment penalty after receiving the preceding explanation, they would simply be informed that the prepayment penalty was not negotiable, and, if they did not want to contend with the prepayment penalty, they should walk away from the closing.  This, of course, very rarely occurred, it was too late, the borrowers needed the cash, or debt relief, and signed on the dotted line.

Prepayment penalty clauses could be avoided when taking out a subprime loan, for an upfront fee.  But this rarely happened.  This rarely happened because subprime borrowers were already paying a large amount of fees to subprime lenders, and adding one more fee, usually one percent (1%) of the mortgage amount, to avoid a prepayment penalty in the future, would eat into the cash subprime borrowers were counting on dropping into their pockets when they closed.

Posted by John Venlet on 04/10 at 05:41 AM
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