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Penalties on New Loans — Yes or No?

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Posted On: 10/22/2014

Question: Please settle an argument: Can lenders charge prepayment penalties on new loans?

Answer: In limited cases they can. Let me explain:

One of the major issues raised by the mortgage meltdown was the use of prepayment penalties. If a borrower had a loan and wanted to refinance or pay off the debt, they often found that to do so within the first few years of origination would require a massive prepayment penalty. Example: Smith took out an option ARM and must pay a 5-percent prepayment penalty if he refinances within the first three years of the loan term. If Smith refinances after 30 months and owes $175,000 he will have to bring an extra $8,750 in cash to closing.

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The cost of the prepayment penalty plus the expense to refinance were too great for many (if not most) borrowers, thus effectively locking them into mortgages with high rates and bad terms. The result was if monthly costs soared they were stuck. For instance, Fitch Ratings estimated in 2008 that the average option ARM payment increased 63 percent once start periods ended, enough to demolish many household budgets.

Even worse, if someone had to sell the property during the penalty period – say for a new job in a distant town – the fee would still apply with some loans even though the mortgage was not being refinanced.

Under the Dodd-Frank Wall Street Reform and Consumer Protection Act the rules are different.

First, the mortgage pie is divided into two parts – qualified mortgages and non-qualified mortgages. An example of a non-qualified loan might be an interest-only jumbo mortgage.

Second, lenders may charge prepayment penalties only with qualified mortgages.

Third, a “qualified mortgage” is an FHA, VA or conventional loan, or a “portfolio” loan that meets certain standards. A portfolio loan is a mortgage that a lender originates and keeps, it is not sold to another lender.

Fourth, there are no prepayment penalties allowed with FHA, VA or conventional loans. Therefore, the only place where you can find a prepayment penalty today is with a portfolio mortgage thsy meets the standards to be a qualified mortgage.

Fifth, the maximum penalty is restricted to the following schedule: 2 percent the first year, 2 percent the second year, 1 percent the third year and nothing thereafter.

Sixth, be aware that a form of prepayment penalty – what are called “post-payment interest charges” – will continue for FHA loans until Jan. 21, 2015. Close after that date and you get a penalty-free FHA mortgage.

FHA loans – which have relatively-modest prepayment penalties equal to no more than one month's interest – can be used to give some sense of how big the problem really is. According to HUD, “nearly two-thirds of borrowers who prepaid their mortgage in full in 2012 paid post-settlement interest. The estimated amount of post-settlement interest these borrowers pay amounts to $449 million.”

For more information speak with lenders. If you're considering an FHA loan and are set to close around the end of January, it might be very much in your interest to assure that you settle after the 21st and that your loan does not allow a post-payment interest fee, a prepayment penalty by any definition.

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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