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Is Prepaying A Loan Still Penalized?

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Posted On: 05/13/2015

QUESTION:

Prior to the foreclosure crisis it seemed fairly common to find mortgages with prepayment penalties. Are such penalty clauses still allowed?

ANSWER:

A prepayment penalty can be seen as a form of interest charged to borrowers who quickly repay a mortgage. The justification for such penalties is that the lender needs the loan to be in place for a given time to assure that the mortgage is profitable.

In practice, what prepayment penalties do is restrict the ability of borrowers to avoid onerous terms or to refinance when rates decline. The size of a prepayment varied with the loan product. For instance, under the old system if a borrower had a $250,000 balance with a 5-percent prepayment penalty that lasts four years, the borrower would owe $12,500 in cash at closing in addition to the loan balance if the debt is paid off early.

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In some cases prepayment penalties did not apply, such as when a house is sold. This is an example of a “soft” prepayment penalty. With a “hard” prepayment penalty the borrower owes even if the loan is paid off because the home must be sold.

Federal Housing Administration, Veterans Affairs and conventional loans do not have prepayment penalties. Instead, penalties prior to the mortgage meltdown were associated with subprime loans and toxic mortgages.

Today the story with prepayment penalties looks like this:

The mortgage market is now divided into two basic parts: qualified mortgages and non-qualified mortgages. Prepayment penalties are prohibited with non-qualified loans, such as jumbo mortgages.

Prepayment penalties are allowed with qualified mortgages – loans with a lot less liability for lenders. To have a qualified mortgage – for lenders to face less liability – the loan must meet certain standards. For instance, with a qualified mortgage there is a fee-and-points limitation – payments must be essentially even – meaning no balloon notes, and lenders must fully document loan applications.

FHA, VA and conventional loans automatically are regarded as qualified mortgages. However, it is also possible for “portfolio” loans – loans lenders originate and keep – to be regarded as qualified mortgages. Such portfolio loans may include prepayment penalties.

Are prepayment penalties now a problem for borrowers? The answer is pretty much no but not entirely no. Here’s why:

First, the overwhelming majority of loans issued today involve no prepayment penalties. (Think FHA, VA and conventional loans.)

Second, the only loans that can have prepayment penalties are portfolio loans that meet the standards for qualified mortgages. The mere fact that a loan is a “qualified mortgage” means that the borrower has many protections that did not exist prior to 2010.

Third, if there is a prepayment penalty, the penalty is limited to 2 percent the first year, 2 percent the second year and 1 percent the third year. After that, nothing. For specifics, speak with lenders.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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