Chat with Charles

The voice on the radio spouts, “…and we never quote rates with prepayment penalties,” suggesting to the poor listener that if they’ve been quoted a rate with one that they – the borrower – is either inferior or got taken to the cleaners by their broker or banker and that the company advertising on the radio is going to do them a good turn by quoting a rate without the prepayment penalty. Anything to try to get the listeners to call. The advertisers – and there are more than one doing it – are creating a fictitious evil just so they can boast that they’re going to come in and save the day. As an ethical human being and business person, it makes me want to tear my hair out (what’s left of it, anyway…)

Prepayment penalties. What are they and do you need ‘em? Simply put, a prepayment penalty is a way for the lender to offer you a lower rate while guaranteeing that they’re going to get some of that discount back in the form of interest payments.

There are two types of prepayment penalties: hard and soft. A “hard” prepayment penalty means you will pay the penalty if you pay off the loan for any reason within the penalty period (typically 2 or 3 years). A “soft” prepayment penalty means you can sell the house with no penalty, but you must pay the penalty if you refinance it within the penalty period.

The soft prepayment penalty is perfect for investors who are looking to buy a place, do some cosmetic repairs and then sell it again for profit. You get the benefit of the lower rate – and payment – with no issues when you go to sell. One of my regular investment clients saved close to $800.00 by going with the rate that had a soft prepayment penalty versus the rate the guy on the radio was going to offer her. Obviously, in this case having a prepayment penalty was actually a good thing for our client.

Rivercrest doesn’t make many loans with prepayment penalties, but when we do, there’s always a good reason for it. The client that I will typically quote a prepayment penalty to is often the same client I’ve been talking to about increasing their credit scores. Let’s say John and Pat have mid-scores of 576 and 590. Those scores mean they’re not going to qualify for that conforming Fannie Mae or Freddie Mac rate of 5.75% on a 30 year fixed rate loan that you read about in the paper Sunday.

I’m going to go through their credit report with them and make sure there are no errors in the report. If there are, I’m going to help them fix the errors. If not, I’m going to talk with them about what they need to do to increase their scores in order to qualify for the 5.75% rate. Chances are very good that part of the process of increasing their scores will involve the passage of time, say 24 months with a new mortgage paid on time and all other accounts paid as agreed, as well.

So I shop the loan around and I’m able to offer them a 30 year loan that is fixed for the first five years at 6.50%, then converts to an adjustable rate loan after that. The loan has a prepayment penalty equal to six months worth of accrued interest on the balance if it’s paid off in the first two years.

Can I quote the clients the same loan without a prepayment penalty? Absolutely. I can offer them 7.00%, for example, for the same product without a prepayment penalty, but why should they pay .500% higher in rate for 24 payments when there’s a strong probability that they’re not going to qualify for a better rate before that, anyway? When we talk to clients in this situation, we have two goals: 1. get the client into a home now, and 2. make a plan that will get them into a better loan within a specified period of time.

The bottom line is this: Any loan can be quoted without a prepayment penalty. It’s just not always the best choice for our borrowers. We’re going to help our clients get the best loan possible for their specific situation. Sometimes that will mean quoting with a prepayment penalty, sometimes not.

Prepayment penalties aren’t evil! If there’s evil in the room, it’s the guy on the radio who misleads you into taking a loan that costs you more than it should. As always, we’re here to answer all your questions. Knowledge is Power!