It's hard to believe now, but in the 1940s, if you sold your house before the 30-year mortgage ended, or if you refinanced, you had to pay a penalty to the mortgage lender.
In other words, the mortgage contract was for the life of the loan. Any attempt to end the contract early would cost you a pretty penny.That sorry situation continued through much of the 1950s and '60s, according to an article in the Freddie Mac trade publication Secondary Mortgage Markets.
Eventually, many states outlawed prepayment penalties altogether and others limited how much lenders could charge. The idea faded.
So it may seem odd that today prepayment penalties are making a small comeback - but with a twist. This time around, they're optional and lenders are holding out a financial carrot to get borrowers to accept them - either a lower interest rate or fewer points or lower closing costs or a combination of those goodies.
Two major national lenders are in the forefront with this type of loan.
Countrywide (800-669-6659) offers 30-year fixed-rate mortgages with a prepayment penalty in 31 states. Generally, you get a quarter-point reduction in the interest rate if you agree to accept a prepayment penalty for the first five years of the mortgage. You can sell the house without paying a penalty, but the penalty kicks in if you refinance.
BankAmerica Mortgage (888-815-2724) offers prepayment penalties only on adjustable rate mortgages at the current time. For example, said Jeff Moering, vice president of portfolio management, the company is now offering a one-year ARM at 6 percent interest with 1 point and a margin of 2.75 percent.
But if you accept a prepayment penalty, the interest rate is reduced to 5.625, the margin is reduced to 2.5 percent and the 1 point is eliminated.
BankAmerica's prepayment penalties last only three years but apply if you sell the house as well as if you refinance.
If the idea of a prepayment leaves you cold, here's another way to think of it. Lenders know that you may decide to refinance your mortgage after a few years and dump the one that they arranged for you. So they build into their mortgages the costs they may incur from losing customers to competitors a few years down the line.
Consumers, said Moering, "pay for the right to prepay. The right to prepay is priced into that mortgage." With a prepayment penalty, "We give them the ability to reduce the cost of the mortgage if they don't really intend to prepay."
He said BankAmerica's prepayment penalty mortgages are popular with financially pressed first-time homebuyers who like the idea of reduced closing costs.
If you choose a mortgage with a prepayment penalty, realize you probably won't be able to refinance profitably during the penalty period. An analysis done by Freddie Mac found that on a $100,000, 30-year mortgage with an interest rate of 7.75 percent and a five-year prepayment penalty, rates would have to drop 2 percentage points before refinancing during the penalty phase would make financial sense.
Jacqueline Doty, a marketing manager for Freddie Mac, said the numbers of prepaid penalty mortgages are still a tiny fraction of the market - less than 1 percent of the loans sold to Freddie Mac and Fannie Mae and worth only about $25 billion in loans held by retail lenders.
If you're interested in such a loan, here are some points to consider:
- If the lower cost of the mortgage will get you into a house you could not otherwise afford, you probably can live with a penalty.
- When mortgage rates are low to begin with, they probably won't fall enough in the next few years to make refinancing worthwhile. So why not get that bonus rate that comes with a prepayment penalty since you won't need to refinance anyway.
- If you've had mortgages before and know from experience that lassitude and the hassle factor will keep you from refinancing no matter where interest rates go, the prepayment penalty is for you.
If you decide on such a mortgage, check with area lenders for the best deal. You may find a variety of packages, including one that fits your particular needs. They're not available in all states, though, since some legislatures have outlawed prepayment penalties.