The Prepayment Penalty Con

This came up in conversation today and was brought about largely because of the turmoil in the real estate lending industry.  The next time a loan agent offers you a loan with a prepayment penalty, take pause and ask some VERY pointed questions.

The primary driving motivation for an A paper loan agent to put anyone into a loan with a prepayment penalty is for them to MAKE MORE MONEY. It is not to reduce the rate but rather for them to further line their pockets with a larger commission.  The typical scenario plays out on the Option ARM program. Watch for quotes with the 1% teaser rate and “we’ll pay all of your costs” language. You’ll typically get a zero point quote with no prepayment penalty or one where they cover all the costs but, oh by the way, there is a 3 year prepayment penalty associated with the no cost option. 

Here is how it works.

When you receive a quote of a zero point loan, the loan agent or lender will have a built in yield in the form of a rebate or yield spread premium. In other words, using the Option ARM scenario, I might get the following 3 options:

1. 1% pay rate, Libor Index, 2.125% margin @ 1.000 point cost

2. 1% pay rate, Libor Index, 2.375% margin, @ 0 points and a 1 year prepayment penalty.

3. 1% pay rate, Libor Index, 2.625 margin, @ no cost and a 3 year prepayment penalty.

Here is how it pans out for the loan agent on a typical $500,000 loan:

1. 1% gross commission ($5,000) at a 70% split = $3,500 in income.

2. 1.25% gross commission ($6,250) at a 70% split = $4,375 in income.

3. 3.375% gross commission ($16,875) less costs (3,000) for a net of $13,875 at a 70% split = $9,712.50 in income.

The game is important to understand because your actual rate (exclusive of the 1% pay rate) is based on the index plus margin.  This means that the underlying, true rate of interest for the above scenarios would be (based on the 6 month Libor index @ 5.320%):

1. 7.445%

2. 7.695%

3. 7.945%

The end result on the no cost with the prepayment penalty is that you are stuck for the next 3 years with an above market rate that, in this scenario, would be .50% higher than where you could have been. That is an overall interest cost hike of $7,500 for the 3 years.  Not to mention that if you had looked at programs other than the Option ARM you could have had a true rate of interest closer to the 6.5% range which now represents 3 year interest savings in excess of $20,000! Some loan agents are so masterful at selling this program that they charge a point upfront and still get paid the 3 to 4 point premium on the back end!

What can you do? Simply avoid loans with prepayment penalties, avoid loan agents that try to sell them to you, and if you are considering taking a loan that has a prepayment penalty then make sure you are gettinig REAL savings and a REAL discount as a result. 

FYI, if working with a mortgage broker, the yield spread premium or that back end income from rebate must be disclosed to you by law.  Look for it on your GFE (Good Faith Estimate) and on the escrow instructions from the Title company.  Protect yourself and save some money and heartache down the road by making sure you are getting a quality loan and working with an ethical loan agent.