When the housing market crashed within the early 2000s, new mortgage guidelines emerged to stop an identical disaster sooner or later.
The Dodd-Frank Act gave us each the Means-to-Repay Rule and the Certified Mortgage Rule (ATR/QM Rule).
ATR requires collectors “to make an inexpensive, good religion willpower of a shopper’s capacity to repay a residential mortgage mortgage in keeping with its phrases.”
Whereas the QM rule affords lenders “sure protections from legal responsibility” in the event that they originate loans that meet that definition.
If lenders make loans that don’t embody dangerous options like interest-only, damaging amortization, or balloon funds, they obtain sure protections if the loans occur to go unhealthy.
This led to most mortgages complying with the QM rule, and so-called non-QM loans with these outlawed options changing into rather more fringe.
One other frequent characteristic within the early 2000s mortgage market that wasn’t outlawed, however grew to become extra restricted, was the prepayment penalty.
Given prepayment danger at this time, maybe it may very well be reintroduced responsibly as an choice to save lots of owners cash.
A Lot of Mortgages Used to Have Prepayment Penalties
Within the early 2000s, it was quite common to see a prepayment penalty hooked up to a house mortgage.
Because the identify suggests, owners had been penalized in the event that they paid off their loans forward of schedule.
Within the case of a tough prepay, they couldn’t refinance the mortgage and even promote the property throughout a sure timeframe, sometimes three years.
Within the case of a smooth prepay, they couldn’t refinance, however might brazenly promote every time they wished with out penalty.
This protected lenders from an early payoff, and ostensibly allowed them to supply a barely decrease mortgage fee to the patron.
In spite of everything, there have been some assurances that the borrower would seemingly hold the mortgage for a minimal time frame to keep away from paying the penalty.
Talking of, the penalty was usually fairly steep, akin to 80% of six months curiosity.
For instance, a $400,000 mortgage quantity with a 4.5% fee would end in about $9,000 in curiosity in six months, so 80% of that will be $7,200.
To keep away from this steep penalty, owners would seemingly dangle on to the loans till they had been permitted to refinance/promote with out incurring the cost.
The issue was prepays had been usually hooked up to adjustable-rate mortgages, some that adjusted as quickly as six months after origination.
So that you’d have a scenario the place a home-owner’s mortgage fee reset a lot larger they usually had been primarily caught within the mortgage.
Lengthy story quick, lenders abused the prepayment penalty and made it a non-starter post-mortgage disaster.
New Guidelines for Prepayment Penalties
As we speak, it’s nonetheless attainable for banks and mortgage lenders to connect prepayment penalties to mortgages, however there are strict guidelines in place.
As such, most lenders don’t hassle making use of them. First off, the loans have to be Certified Mortgages (QMs). So no dangerous options are permitted.
As well as, the loans should even be fixed-rate mortgages (no ARMs allowed) they usually can’t be higher-priced loans (1.5 proportion factors or greater than the Common Prime Provide Fee).
The brand new guidelines additionally restrict prepays to the primary three years of the mortgage, and limits the price to 2 p.c of the excellent stability pay as you go in the course of the first two years.
Or one p.c of the excellent stability pay as you go in the course of the third yr of the mortgage.
Lastly, the lender should additionally current the borrower with an alternate mortgage that doesn’t have a prepayment penalty to allow them to evaluate their choices.
In spite of everything, if the distinction had been minimal, a shopper won’t need that prepay hooked up to their mortgage to make sure most flexibility.
Merely put, this laundry record of guidelines has mainly made prepayment penalties a factor of the previous.
By no means thoughts that Fannie Mae additionally says it gained’t purchase loans with prepayment penalties, per their Accountable Lending Practices.
However now that mortgage charges have surged from their report lows, and will pull again a good quantity, an argument may very well be made to carry them again, in a accountable method.
May a Prepayment Penalty Save Debtors Cash As we speak?
Recently, mortgage fee spreads have been an enormous speaking level as a result of they’ve widened significantly.
Traditionally, they’ve hovered round 170 foundation factors above the 10-year bond yield. So should you wished to observe mortgage charges, you’d add the present 10-year yield plus 1.70%.
For instance, at this time’s yield of round 4.20 added to 1.70% would equate to a 30-year mounted round 6%.
However due to current volatility and uncertainty within the mortgage world, spreads are almost 100 foundation factors (bps) larger.
In different phrases, that 6% fee is perhaps nearer to 7%, to account for issues like mortgages being paid off early.
Plenty of that comes all the way down to prepayment danger, as seen within the chart above from Rick Palacios Jr., Director of Analysis at John Burns Consulting.
Lengthy story quick, numerous owners (and lenders and MBS traders) anticipate charges to return down, regardless of being comparatively excessive in the meanwhile.
This implies the mortgages originated at this time gained’t final lengthy and paying a premium for them doesn’t make sense in the event that they receives a commission off months later.
To alleviate this concern, lenders might reintroduce prepayment penalties and decrease their mortgage charges within the course of. Maybe that fee may very well be 6.5% as an alternative of seven%.
In the long run, a borrower would obtain a decrease rate of interest and that will additionally scale back the chance of early reimbursement.
Each due to the penalty imposed and since they’d have a decrease rate of interest, making a refinance much less seemingly until charges dropped even additional.
After all, they’d must be applied responsibly, and maybe solely supplied for the primary yr of the mortgage, possibly two, to keep away from changing into traps for owners once more.
However this may very well be one strategy to give lenders and MBS traders some assurances and debtors a barely higher fee.
Earlier than creating this web site, I labored as an account government for a wholesale mortgage lender in Los Angeles. My hands-on expertise within the early 2000s impressed me to start writing about mortgages 18 years in the past to assist potential (and current) dwelling consumers higher navigate the house mortgage course of. Comply with me on Twitter for decent takes.