Why you’re paying more.
A friend of mine once asked why it cost her more than a thousand dollars to pay off her loan early. She wondered, “… Shouldn’t I be even given a discount for paying way ahead of time?” I thought of one thing right away – prepayment penalties.
A prepayment penalty is a fee that lenders collect from borrowers when the loan is paid off early. My friend may not have been informed that her loan carries such rule in the contract. In the end, she had no choice but to cover the cost.
Keep in mind though that a loan may or may not carry a prepayment penalty. Subprime loans for example, carry a fee from 1.5 to 3 percent of the loan balance. Buying the loan out earlier will also increase the interest rate. For those who can find loans without such fee, it may or may not work for you.
Prepayment penalties may hurt you in different cases. If it’s a soft prepayment fee, you’d only pay it when you refinance. However, if it’s a hard prepayment penalty, you’d be paying it when you either refinance or sell the house. But is it all bad?
Not entirely. Borrowers can use the fee to their advantage. For example, if it would reduce the payment terms by a significant amount of time, it can make a huge difference in their personal savings. That is, if the prepayment penalty is actually lower than the savings that he can get. If not, then he’d be thinking twice on completing his mortgage payments.
So the problem also lies in the part of most lenders who advertently skip the prepayment penalty explanation. The result? You’ll have frustrated borrowers who lose their trust on their lenders. This is a good source of additional income for these scrupulous thieves who contend that they need the fees to cover the high cost of loan origination.
In a report by the Wall Street Journal, “… Some consumer advocates and politicians contend that borrowers aren’t being adequately informed of the prepayment penalties, which critics characterize as a “predatory” lending practice aimed at low-income people who may not fully understand loan terms. ‘Prepayment penalties rip money out of people’s pockets,’ says Lisa Donner, a coordinator with the Association of Community Organizations for Reform Now, or Acorn, a nonprofit and activist group that often targets housing issues. ‘Owning a home goes from being a source of wealth into a constant drain.'”
It will take a miracle to turn things in favor of the borrower when prepayment penalties will be banned like in the mid-1908s. For now, borrowers should be aware that when originating their loans, they need to demand a thorough explanation for each statement that’s written on paper.