Prepayment Penalties Do Not Lower Interest Rates

Recent research done by the Center for Responsible Lending (CRL) has raised some disquieting allegations of a correlation between foreclosure, prepayment penalties, and race, in some areas. According to its website, the Center is "a nonprofit, nonpartisan research and policy organization dedicated to protecting homeownership and family wealth by working to eliminate abusive financial practices." The studies done by the CRL are typically well-researched and fairly comprehensive, and we have referred to their work before.

The research indicates that borrowers living in minority areas who have sub-prime mortgages (meaning their credit was not great when they first obtained their loan), are nearly 35% more likely to have prepayment penalties for their loan than if they were living in white neighborhoods. In an article by Originator Times, Hilary Shelton, Director of the NAACP Washington, DC Bureau, states that the report from the CRL "provides more empirical evidence that African-Americans are second-class citizens in the subprime market, and that skin color determines the terms of credit that a family receives."

More disturbing is the evidence that having a high prepayment penalty for a mortgage does nothing to affect the interest rate of the loan. In fact, quite the opposite is true. Thirty-year loans have an average interest rate that is 40 basis points higher than expected for a subprime loan with a prepayment penalty. This is surprising, mainly due to the fact that sellers of these loans often tell consumers that the prepay penalty acts to lower the interest rate and monthly payment. However, this clearly seems to be a lie on the part of some mortgage companies, used to trick homeowners into paying higher costs both through the monthly payment and when the homeowners attempts to sell or refinance.

Increasing mortgage payments through ARMs and high prepayment penalties are two of many circumstances that can cause homeowners to face foreclosure and then find themselves locked into their home. As interest rates rise, and payments dramatically go up, victims of foreclosure may not be able to stop foreclosure by selling or refinancing before the home is lost.

While the loan is in default, but not in foreclosure, the prepayment penalty increases the cost of paying off the loan, making it more difficult to qualify for alternate financing. And by the time the loan goes into foreclosure, the bank may have to give up the prepay, but the extra interest, late fees, and court costs may be much higher than the original prepayment penalty. This sequence of events can lead to the homeowners not being able to stop foreclosure either before or after the foreclosure process has begun in earnest.