Do Prepayment Penalties Help Consumers by Lowering Rates?
With Senator Dodd aiming his sights on predatory lending, perhaps his first target should be prepayment penalties, which I have mentioned in passing before. The typical penalty for a subprime consumer who repays his loan early (usually by refinancing with another lender), is about six months worth of interest. While prepayment penalties are themselves objectionable terms, they also function to lock consumers into loans that are otherwise onerous. Its a form of monopoly power, preventing other lenders from competing to replace a bad loan with a better one.
The mortgage lending industry includes the penalties primarily in their sub-prime loans, on the argument that the lender incurrs lots of upfront costs that it should be allowed to recoup if the borrower chooses to breach its contract by repaying early, thereby depriving the lender of its expectancy, which is the total interest and the stable repayment stream over time. (Believe it or not, there was a time when common law courts refused to allow early repayment whatsoever.) Without such a penalty, lenders argue that they would have to charge higher interest rates.
Does the evidence bear this out? ....
In Gregory Squires' 2004 book, Why the Poor Pay More, Keith Ernst, Deborah N. Goldstein, and Christopher A. Richardson provide some compelling analysis:
[L]enders who claim to be providing a reasonable a reasonable benefit to borrowers in the form of decreased monthly costs in exchange for the acceptance of a prepayment penalty have been showing to provide considerably less than equitable exchanges. For example, one finance company affiliate of a national bank [CitiFinancial] reported that it provided a reduction of 0.50 percent in interest for borrowers who chose [!] a prepayment penalty. Yet, a borrower who has to pay a six month's interst prepayment penalty to refinance at year three of a 12 percent interest, 30-year home loan, roughly the average life of subprime loans for many originators -- will have received a benefit worth less than 2 percent of the loan amount, but may be liable for a penalty of almost 5 percent of the loan amount. In other words, for the majority of borrowers facing this prospect, such a prepayment penalty-interest rate exchange will be a losing proposition.
(Squires 108 citations omitted)
Just a few comments: First, it is hard to read phrases like "for borrowers that chose a prepayment penalty" with a straight face. As we know, these are contracts of adhesion, and there is not any real negotiation or choice over contract terms going on. Rathe consumers for the most part take what they get.
Second, the harmfullness of prepayment penalties will be exacerbated when consumers are also targetted with an agressive flipping strategy. I've personally seen cases where consumers were persuaded to refinance, with prepayment penalties, every six months. They got a little cash back each time (which they then used to pay the mortgage), but meanwhile their equity was disapearing like water through a seive, given the front-end fees and back-end penalties each time. Now that the market has stopped appreciating, the lenders say game over and just take the house.
Finally, of course, the prepayment penalty will be exacerbated when consumers relied on mortgage brokers who stuck them with even worse interest rates than they would otherwise qualify for. (It's just about impossible for a subprime consumer to compare rates, given that each lender would require a new credit check which further harms their credit rating.) In exchange for this service of sticking the consumer with a bad loan, the broker gets a fat check from the lender (called a yield spread premium). Now the consumer has a bad loan, which means that she even more desperately needs to get out of it by refinancing, but the prepayment penalty is correspondingly larger (since it is based on the interest rate).
As ugly as all this is, one might be tempted to assume that these practices are already illegal. That would be a mistake.
I have mixed feelings here.
If consumers can be convinced to refinance more than once with substantial pre-payment penalty, then they are rather stupid, or, as some people put it, innumerate.
Perhaps a good regulation would be to
(a) restrict the ways of pricing loans to as few as possible if they are financially equivalent, to minimize the confusion
(b) have a well written very didactic brochure that would had to be supplied to a customer at least one day before loan agreement takes force. Abusive lenders could be required to pay for free financial counceling by a government agency (or contractors working for the government, although I would prefer it less).
I think that pre-payment penalty is equivalent with points: when you take the loan, some number of points is added to the loan amount, and amortized points are for tax reporting purposes equivalent to interest. When you pay the loan early, the points are lost.
Penalty in terms of some amount of time worth of interest can be subtly non-equivalent, but if the difference is small, only one way of formulating the penalty should be allowed, to make it easier for the consumers to compare.
A more general problem, innumerate consumers interacting with all-to-numerate financial companies, exists on all levels of the financial markets.
January 11, 2007 11:35 AM | Reply | Permalink
The first clue that "pre-payment penalties" ought not to be allowed is in what they call it. It's not really a "penalty," because early payment is an attribute of thrift and diligence, both of which are to be encouraged, not penalized.
Really, it's insurance for the lender against (1) loss of interest stemming from early payment, and more insidiously (2) a possible rise in the credit-worthiness of, or the availability of lower rates to, the borrower, who may then want to refinance the (typically, home mortgage) note with a different lender at a lower interest rate, and will have to cough up the prepayment penalty at refinancing time.
The societal value of prompt debt repayment ought not to be clouded with these misleadingly-named "pre-payment penalties," whereby borrowers are put in the unusual posture of being penalized for being late and for being early.
Lenders will say that their actuaries tell them that PPs are a useful tool, but so is the crowbar used to break into your car. Absence of PPs leaves some flexibility in the hands of the borrower, and I dare any lender to make an actuarial case that they cannot lend money to someone without a PP. They can condense all their concerns into the interest rate.
http://www.responsiblelending.org/issues/mortgage/briefs/page.jsp?itemID=28012076
If these bastards had their way, we'd all be living month-to-month with a portrait of Ayn Rand above the coin-operated gas meter in our living/dining/bedroom.
January 11, 2007 12:33 PM | Reply | Permalink
I have to say that I was on the "other side" as well: I purchased a callable municipal bond. Of course, it was called when the interest rates were low. As an individual, you have hard time figuring how good deal are you getting with such a bond when you compare it with non-callable bonds.
When mortgages are securitized, they are probably converted into packets of callable and non-collable bonds (and some other stuff, "strips"? ooght). Some compensation for the risk of early payment of the debt is not per se a bad thing.
However, if this is package in two different ways, as points and as pre-payment penalty, the comparisons are hard and this is true reason why is it done. The consumer may have to choose three parameters: duration of the loan, the interest rate, and points. Three parameters are already a bit hard to compare even when you are totally conversant with the underlying algebra. The good question to financial companies is not "why you want to offer the penalty" but "why you want to package the penalty in two different ways".
The obvious reason is that once the "prepayment penalty" is translated into points, and the customer compares the loan condition with some table available at website advertising and comparing mortgage loans, the comparison may look very awful indeed.
The second reason is that subprime loans are suppose to compensate, with higher interest rate, for the risk of default. If this risk is priced properly, there should need be no reason for particularly high penalty/points: the lender risks early payback or default, but needless to say, early payback nixes the risk of te default, so "net risk" should be minuscule. Hard to see then why high interest loans should have more points or point equivalent than low interest loans.
January 11, 2007 2:09 PM | Reply | Permalink
Maybe a better option to protect the lender is a right of first refusal. Say you have lousy credit and can only get a sub prime loan. After a few years you have made all your mortgage payments on time and paid down your other debt, now lots of banks are more than happy to re-fi you into a conventional loan, the original lender would be able to match any loan you qualified for to keep your business.
January 11, 2007 3:17 PM | Reply | Permalink
pre-payment penalties are not in and of themselves predatory. like interest rates and late fees they ought to be regulated to prevent abuses and predatory practices. but pre-payment penalties are not used exclusively in sub-prime lending. they can be perfectly acceptable terms to consumers.
while i do think special attention ought to be paid to prevent predatory practices particularly in the business of sub-prime lending, as a real estate professional i am always wary of attempts to 'protect consumers' in that more often than not those attempts end up hurting more consumers than they end up protecting.
recentish fha regulations, for example, aimed at preventing predatory and fraudulent 'flipping' have actually served to slow rehabilitation in neighborhoods most in need of reinvestment and reduce the supply of decent affordable housing for the consumers fha underwriting is supposed to serve.
also, i think it is worth keeping in mind that for consumers whose only option is the sub-prime market, it is not always the best financial decision to buy a home, pre-payment penalties or not. often times it is better for the consumer to wait and rent and rebuild their credit before purchasing a home. but the financial implications are not always the most important factors in a family's decision to purchase a home.
January 12, 2007 8:38 AM | Reply | Permalink
This conclusory statement was not supported by anything. Can you explain what benefit prepayment penalties serve consumers?
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January 12, 2007 4:46 PM | Reply | Permalink
I have tried to explain.
I claim that the difference between ubiquitous points on mortgage loans and pre-payment penalties for sub-prime lending is sufficiently subtle to regard them as equivalent. The lender may value the security of the loan duration, so the consumer may "sell it" if he/she is so inclined.
If so then
a. there is nothing "inherently detrimental" in these penalties
b. there is no extra benefit to industry or customers from that practice other than making loan pricing more obscure; that is indeed predatory -- confusing the least savvy class of consumers into making even worse deals than their reduced circumstances make possible.
January 13, 2007 6:33 PM | Reply | Permalink
Well, mortgage lenders typically offer (or did when I bought a house) a choice of interest rates based on the number of points (down to and including zero) which the borrower is willing to pay. That makes the points different from PPs, because they are in a sense voluntary. The borrower just has to balance the up-front payment of points and lower rate on the one hand vs. fewer or no points and a higher rate on the other. The length of time the borrower expects to be in the house also matters, and I would argue it is a fourth "parameter," after the duration of the loan, the interest rate, and the points.
But the sub-prime borrower has to eat the PP provision, and cannot bargain it out of the deal, correct?
January 13, 2007 11:54 PM | Reply | Permalink
Sounds good, but isn't the whole idea that they want you to be unable to refinance because you can't afford the PP?
January 13, 2007 11:59 PM | Reply | Permalink
Any way you cut it, customers who represent higher credit risk will not get as good deals than those who can make 25% downpayment etc.
So they will get fewer deals, and this is not voluntary.
So what is the difference, in the bottom line, between offering bad deals with a lot of points and offering bad deals with pre-payment penalty?
Offering bad deals does not have to be abusive. Offering them in a manner that hides their nature is abusive. I recall when on vacations a gas station in WY was offering gasoline priced per liter. I asked how much it is per gallon -- the attendant did not know. A quick calculation showed that this was not a good price (surprise?)
If sub-prime lenders had to offer points, their loans would be easy to compare, and they would look awful. Many customers would decide to keep renting rather then paying for a truly awful mortgage. Or be more motivated to shop over the internet, consult more numerate family members etc.
January 16, 2007 10:39 AM | Reply | Permalink
"So what is the difference, in the bottom line, between offering bad deals with a lot of points and offering bad deals with pre-payment penalty?"
One difference is, the borrower pays points up front, but doesn't have to lose a huge chunk of equity to the PP if he pays off early. PPs are designed to "pop up" to prevent or discourage refinancing. Points are not, and do not.
January 22, 2007 10:57 PM | Reply | Permalink