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Prepayment Penalties, Balloon Payments Increase Foreclosure Risk Staff - Mortgage Lenders Plus.com

Some activities invite heartbreak and loss: driving without a seat belt, marrying someone after one date, experimenting with heroin. Add another to the list: getting a home loan with a prepayment penalty or balloon payment.

People who refinance their mortgages with loans containing prepayment penalties or balloon payments are more likely to undergo foreclosure, according to a study by researchers at the University of North Carolina.

Prepayment penalties and balloon payments are most often found in subprime mortgages (higher-rate home loans for borrowers with flawed credit). It's common sense that these loans have higher foreclosure rates, and this research backs it up with hard evidence, says one of the authors.

"Our study for the first time really definitively gives you the order of magnitude of the additional risk of foreclosure that are posed by these terms," says Michael Stegman, director of the Center for Community Capitalism at the University of North Carolina in Chapel Hill.

The study, by Stegman, Walter Davis and Robert Quercia, estimates that a prepayment penalty increases foreclosure risk by about 20 percent, after compensating for factors such as income and credit score.

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Mortgages with balloon payments were 46 percent more likely to go to foreclosure than loans without balloon payment provisions to comparable borrowers, according to the study of more than 122,000 subprime refinance mortgages originated in 1999.

Prepayment penalties punish borrowers for refinancing, and balloon payments punish borrowers for not refinancing. A prepayment penalty is levied on the borrower for paying off the mortgage early whether by refinancing the loan or selling the house. A balloon loan requires the outstanding balance to be paid in a lump sum after a set period.

Almost 72 percent of the mortgages in the study had prepayment penalties, usually lasting three or more years. About 14 percent of the mortgages had balloon provisions. About 80 percent of balloon loans have prepayment penalties, Stegman says.

In a theoretical worst-case scenario, the two loan provisions could bump into each other: A borrower could be forced to pay a prepayment penalty for refinancing within five years of getting the loan, and could be forced to make a balloon payment of the entire balance at the mortgage's five-year anniversary. Few, if any, lenders would be that diabolical. But federal laws wouldn't prohibit it.

In the study, a common prepayment penalty was a fee of six months' interest on the outstanding balance. That means that someone who borrowed $100,000 at 12 percent interest, and who then sold the home a year later, would have to pay a penalty of almost $6,000 for paying off the loan early.

Without a prepayment penalty, a homeowner with an unaffordable mortgage can get out of financial trouble by refinancing the loan or selling the house. A prepayment penalty can trap a borrower into keeping the unaffordable loan past the point of no return into delinquency, foreclosure and eviction.

Prepayment penalties and balloon payments are abusive and predatory, say Stegman and fellow critics of subprime loans. They are costly, are applied unfairly, lead to foreclosures, and don't even give borrowers a break on interest rates, says Keith Ernst, senior policy counsel for the Center for Responsible Lending in Durham, N.C.

That last assertion is disputed by the subprime lending industry. Ameriquest, the biggest subprime lender, has best-practices guidelines that pledge "to show borrowers how they can reduce their rates through discount points and prepayment options."

New Century Financial Corp., the second-biggest subprime mortgage lender, says that it does not make or buy loans with balloon payments. As for prepayment penalties, New Century says it offers loans with and without them: "When a borrower opts for a loan with a prepayment charge, the borrower benefits from a lower interest rate or pays lower upfront fees," its guidelines say.

Nevertheless, Ernst, in a report issued this month by the Center for Responsible Lending, concludes that on subprime refinance loans, there is no significant difference in rates between mortgages with prepayment penalties and those without, "as borrowers receive the burdens of penalties without the compensating benefits."

"Once the penalty is in place," Ernst adds, "the borrower's ability to build wealth is significantly hampered since the borrower either continues to pay excess interest or gives up accumulated home equity to get a better loan."

The University of North Carolina study says that, of the borrowers who got loans with prepayment penalties, 37 percent ended up paying the fees, either because they refinanced or they sold their homes. "These penalties, if fully enforced, generated hundreds of millions of dollars for lenders at the expense of borrower equity," the report says.

On the Net: www.ccc.unc.edu

www.responsiblelending.org/reports/PPP2005.cfm

www.kenan-flagler.unc.edu/assets/documents/foreclosurepaper.pdf

www.kenan-flagler.unc.edu/assets/documents/foreclosuretables.doc

Rates across the board were relatively stable in the last week. The benchmark 30-year fixed-rate mortgage fell 3 basis points to 5.68 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week's survey had an average total of 0.33 discount and origination points. One year ago, the mortgage index was 5.72 percent.

The benchmark 15-year fixed-rate mortgage fell 3 basis points to 5.14 percent. The benchmark one-year adjustable-rate mortgage rose 4 basis points to 4.48 percent.

(Distributed by Scripps Howard News Service. E-mail Holden Lewis at hlewis(at)bankrate.com)