Friday, July 11, 2008

Prepayment Penalties

by Tanta on 7/11/2008 02:00:00 PM

I hate prepayment penalties and always have. In theory, they work just like an early withdrawal penalty on a certificate of deposit: you are paid a higher rate of interest in exchange for giving up liquidity for a stated period of time. In the case of mortgage loans, you are (presumably) offered a lower interest rate in exchange for giving up liquidity for a stated period of time.

In reality, few borrowers are, in my experience, capable of calculating the relative savings of the penalty loan accurately, or fully assessing the risk they take by accepting the penalty. This is without even getting into issues of predation or steering or failure to disclose adequately.

Case in point, from the Sacramento Bee:

When Carol Wallace sold her Sun City Roseville home two years ago, she got an expensive reminder from her lender.

She owed $5,964. Why? She had paid off her adjustable-rate mortgage early.

The lender offered to waive it, Wallace said, if she'd buy another house with one of their loans. But here was the point: She had cancer and didn't intend to buy again. She had to pay up.

Two years later, still ill, Wallace still fumes.

"It's written in my paperwork when I die to remind my kids," she said. "It says if there's a class action lawsuit, to remember me, to get my $6,000." . . .

Wallace said she knew she had a prepayment penalty. "But I didn't think it would be a problem because I didn't think I would have to move," she said.
Very few people, I suspect, make any decision about buying or financing a home, including but not limited to the prepayment penalty option, based on their fear that they might be diagnosed with a disabling disease in the next three years. We tend to think that people who obsess about very low-probability, very high-severity events are, well, obsessives.

Wallace was, unfortunately, the one it happened to. I suspect she thought--perhaps we all think--there should be some sort of "hardship exclusion" in her case. But there isn't one, and people sign these things all day without worrying that there isn't one. Perhaps they think to themselves, as Wallace did, that they would only move if they were forced to. By a hardship. Which isn't excluded.

And Wallace thinks she should be part of a "class action." I am trying to imagine how large a "class" of borrowers who suffered a very low-probability event would be.

I have myself come to the conclusion that prepayment penalties should be banned entirely. Not because Ms. Wallace's logic makes any sense to me, but because it doesn't make any sense to me but I suspect it does to most people with a prepayment penalty. And that is evidence enough that consumers cannot understand them.