When it comes to mortgages, it doesn’t always pay to pay early
Wisconsin State Journal Business Section

March 13^th 2005
By Ruth Simon
The Wall Street Journal
 

Many homeowners who are rushing to refinance as interest rates rise may find themselves facing some unexpected terms: Their lenders have set a trap for them if they decide to pay the loan off early.

Prepayment penalties—requiring borrowers who close out loan in the first few years to fork over some extra cash—have long been common on the so-called subprime mortgages issued to borrowers with blemished credit records. But they are increasingly showing up on adjustable-rate mortgages, or ARMs.

The penalties, which usually kick in on loans that are repaid within one to three years, are especially common on popular “option ARMs” which carry low introductory rates. Between 40 and 70 percent of option ARMs now carry prepayment penalties, depending on the lender, according to Gyan Sinha, a senior managing director at Bear Stearns Cos.

David Soleymani, a mortgage broker in Los Angeles, estimates that “half the lenders in the country” now offer loan options with prepayment clauses. At the same time, more lenders are adding “early-termination fees” to home-equity loans and lines of credit that can mean higher costs if the loan is closed too soon.

Lenders say they offer prepayment clauses on mortgages as an option to borrowers seeking a better deal. In exchange, homeowners may pay fewer points or reduce their rate by one-eighth to one-quarter of a percentage point. Borrowers can typically pay off as much as 20 percent of the loan balance without triggering the penalty.

But prepayment penalties can sting, particularly when mortgage rates are moving up or down at a rapid clip. During the refinancing boom, prepayment clauses made it difficult for some borrowers to refinance and take advantage of lower rates. Now that rates are moving upward, prepayment penalties can mean higher costs for borrowers who want to pull out extra cash or refinance to protect against future rate in creases.

State laws can affect just how much of a penalty is charged; some states, such as New Jersey and Pennsylvania, prohibit them, according to the Center for Responsible Lending, though not all lenders are subject to these rules.

At World Savings, a unit of Golden West Financial Corp, borrowers who take out a mortgage with a prepayment clause typically must pay 2 percent of the outstanding loan balance if they pay off the loan in the first three years. Countrywide Financial Corp. offers loans with one-and three-year prepayment penalties—typically six months’ interest on 80 percent of the amount paid off.

At Washington Mutual Inc., borrowers who elect an option ARM are required to accept a one-year prepayment penalty if they pay less than 0.5 percent in points. They can also choose a three-year penalty in exchange for a lower rate.  Hybrid ARMs that carry a fixed rate for the first year typically have a three-year prepayment penalty unless the borrower pays at least 1 percent in points. (These arrangements apply to loans originated through the company’s retail stores.)

MORTGAGE BROKERS CAN MAKE MONEY OFF PENALTIES
Prepayment penalties are attractive to lenders and investors who buy pools of mortgages because they reduce the chance that the borrower will quickly refinance—and provide a payoff if the borrower does. In addition, mortgage brokers can often earn more if they put a customer in a loan with a prepayment penalty.  “On a big loan, it can be as much as $10,000” says Mitchell Ohlbaum, president of Legend Mortgage Corp., a mortgage broker in Los Angeles.  At some banks, loan officers can also earn extra for putting borrowers into loans with these features.

Some borrowers don’t even realize their mortgage has a prepayment clause. Christopher Clyne, a cardiologist in West Hartford, Conn., was surprised to find he was facing a prepayment penalty of about $15,000 when he went to refinance is $750,000 option ARM in late December.  “We found out at the 11^th hour,” recalls Clyne. “It nearly scuttled the deal.” He says his mortgage banker, Michael Menatian, convinced the lender to hold the rate on the new loan for a couple of weeks until the penalty expired.

Other borrowers decide refinancing is worth the cost of the penalty.  Roger Behrstock, the owner of Pride Flight Associates, a jet aviation charter company in Beverly Hills, Calif., was hit with an $8,900 prepayment penalty when he decided to refinance his $890,000 short-term ARM last year. Behrstock went ahead with the new loan anyway, because he needed extra cash for his company. The new mortgage also lowered his payments by $1,800 a month.

Some lenders are stricter than others.  Countrywide Financial charges a prepayment penalty if the borrower sells or refinances the property.  At World Savings, prepayment penalties are waived only if the borrower refinances with World Savings or sells the home and buys another home using a World Savings mortgage. GMAC Mortgage, a unit of General Motors Corp., typically waives the penalty on its option ARM if the home is sold.

HOME EQUITY LOANS CARRY CLAUSES
Borrowers with home-equity loans can also find themselves hit with extra costs if they close their loan too soon. Some 41 percent of lenders now offer home-equity loans with early-termination clauses, up from 24 percent in 2001, according to a survey done by Benchmark Consulting international.