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New financing without penalty?

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Posted On: 08/20/2008

Q: If the borrower has a prepayment penalty, can they still apply for new financing to stave off foreclosure without having to pay the prepayment penalty in full? My prepayment penalty expires November 2008 and the rate is adjusting upward every month, making it difficult to maintain the home. We do not want to go into foreclosure.

A: A mortgage is a contract between a lender and a borrower. The borrower gets cash and in exchange agrees to pay back the lender and to meet certain terms.

In the usual case prepayments have no justification except to increase the lender’s yield from the loan. A big exception would be a situation where a lender pays some or all of the borrower’s closing costs and thus needs to the loan to be outstanding for a certain minimum period to recoup its investment. Also, lenders may offer a lower rate in exchange for a prepayment penalty, but such exchanges often have dubious value.

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“Prepayment penalties,” says the National Association of Realtors, “often trap borrowers in loans they cannot afford by making them too expensive to refinance. While some lenders may, in fact, offer lower rates in exchange for a borrower agreeing to a prepayment penalty, in the experience of many Realtors, that option is not typical. A 2005 study by the Center for Responsible Lending concluded that borrowers with subprime loans and prepayment penalties do not receive lower interest rates, and may actually pay higher rates.”

Prepayment penalties can be huge. Carolyn Warren, an experienced lender and the author of “Mortgage Rip-Offs and Money Savers” (Wiley, 2007) says a typical prepayment penalty can be the equivalent of six months’ interest on 80 percent of the outstanding loan balance. Using this formula, if your loan balance is $200,000, and you have a 6 percent interest rate, the penalty would be $4,800. ($200,000 x 80% = $160,000. $160,000 x 6% = $9,600. $9,600 divided by 2 = $4,800.)

If you look at the prepayment formula you can see an oddity: Suppose the prepayment period lasts three years. The penalty cost changes very little because the loan balance is reduced by only a small amount in the first few years of the loan. A “fairer” arrangement would be for a penalty that’s reduced each month the loan is outstanding, but fairness is not the goal.

In your situation you have a contract with one lender that requires a prepayment penalty. Getting a loan with a second lender would allow you to pay off mortgage No. 1, but paying the loan early will still set off the prepayment penalty.

What can you do?

First, contact your current lender and ask if they will waive the penalty. This is unlikely, but they may agree if you refinance with them. If they agree to a waiver, get it in writing.

Second, get a letter from your lender showing the exact date the loan can be paid off without a penalty. You want this information in writing to assure that it’s correct.

Third, arrange closing on your replacement mortgage to occur after the prepayment penalty period ends for the first loan.

Fourth, be wise – make sure your replacement financing does not have a prepayment penalty.

Most likely you are locked into your current loan until the prepayment period ends. November is not that far off, so the best strategy until you get a new loan is pay all your bills on time and in full to keep up credit and to live frugally for the next few months.

Q: I am told that I do not qualify for the FHASecure program because my loan balance is larger than the amount my home is worth. I’m trying to be proactive so as not to fall behind, but once my mortgage re-sets in November I will not be able to afford my mortgage. What can I do?

A: In the period between October 1, 2007 and June 15 2008, only 3,079 delinquent conventional loans were refinanced under the FHASecure program. In contrast, RealtyTrac.com reports that more than 8,000 homeowners a day were getting foreclosure notices in May.

Keep trying the FHA, but also see if you can work out a loan modification with your lender, something that results in lower payments for at least three years – and then sell or refinance the house before higher payments kick in.

Do not let anyone suggest that you purposely miss mortgage payments to somehow “qualify” for a new loan. Your credit will be destroyed, thus reducing your ability to cheaply refinance.

Lastly, contact your state and local governments to see if they can help modify your current loan or get new financing.

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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