When the housing market collapsed in the early 2000s, new mortgage rules emerged to prevent a similar crisis in the future.
Dodd-Frank Act give We have both the Ability to Repay Rule and the Qualified Mortgage Rule (ATR/QM Rule).
The ATR requires creditors to “make a reasonable, good faith determination about a consumer’s ability to repay a residential mortgage loan according to its terms.”
While the QM Rule provides lenders with “certain liability protections” if they originate loans that meet this definition.
If lenders make loans that don’t include risky features like interest-only, negative amortization, or balloon payments, they get certain protections if the loans go sour.
This resulted in most mortgages becoming compliant with the QM rule, and so-called non-QM loans with those prohibited features becoming much more marginal.
Another common feature of the mortgage market in the early 2000s that has not been banned, but has become more restricted, is the prepayment penalty.
Given the risks of prepayment today, it may be possible to responsibly reintroduce it as an option to save homeowners money.
Many mortgages had prepayment penalties
In the early 2000s, it was very common to see a prepayment penalty associated with a home loan.
As the name suggests, homeowners are penalized if they pay off their loans ahead of schedule.
In the case of a hard prepayment, they were unable to refinance the mortgage or even sell the property within a certain time frame, usually three years.
In the case of easy prepayment, they cannot refinance, but they can sell openly whenever they wish without penalty.
This protected lenders from early repayment, and ostensibly allowed them to offer a slightly lower mortgage rate to the consumer.
After all, there has been some assurance that the borrower is likely to keep the loan for at least a period of time to avoid paying the penalty.
Speaking of which, the penalty was often quite hefty, like 80% of the interest for six months.
For example, a loan amount of $400,000 at a 4.5% interest rate would yield about $9,000 in interest over six months, so 80% of that amount would be $7,200.
To avoid this hefty penalty, homeowners will likely hold on to the loans until they are allowed to refinance/sell without incurring fees.
The problem was that prepayment was often tied to adjustable-rate mortgages, some of which adjusted six months after they were originated.
So you would have a situation where the homeowner’s mortgage rate reset to a much higher level and they were essentially stuck with the loan.
In short, lenders abused the prepayment penalty and made it into a post-mortgage crisis.
New rules for prepayment penalties
Today, it is still possible for banks and mortgage lenders to impose prepayment penalties on a mortgage, but there are… Strict rules In his place.
As such, most lenders are not interested in applying them. First, the loans must be qualified mortgages (QMs). So no risky features are allowed.
In addition, the loans must also be fixed-rate mortgages (no ARMs allowed) and cannot be cap-rate loans (1.5 percentage points or more from the average prime offer rate).
The new rules also limit down payments during the first three years of a loan, and cap the fee at 2 percent of the outstanding balance paid in advance during the first two years.
Or one percent of the outstanding balance paid in advance during the third year of the loan.
Finally, the lender should also offer the borrower an alternative loan that does not include a prepayment penalty so they can compare their options.
After all, if the difference is small, the consumer may not want to tie the prepayment to their loan to ensure maximum flexibility.
Simply put, this laundry list of rules has made prepayment fines a thing of the past.
But now that mortgage interest rates have risen from record lows, and you can withdraw a fair amount, it may be possible to make a case for bringing them back in a responsible way.
Can a prepayment penalty save borrowers money today?
Recently, mortgage interest rate spreads have been a big point of discussion because they have widened significantly.
Historically, it has hovered around 170 basis points above the 10-year bond yield. So, if you want to track mortgage rates, you can add the current 10-year yield plus 1.70%.
For example, today’s yield of about 4.20 plus 1.70% would equal a 30-year fixed yield of about 6%.
But due to recent volatility and uncertainty in the mortgage world, spreads are about 100 basis points higher.
In other words, a 6% rate might be closer to 7%, to account for things like paying off your mortgage early.
Much of this is due to prepayment risk, as shown in the chart above Rick Palacios JrDirector of Research at John Burns Consulting.
In short, many homeowners (and lenders and mortgage bond investors) expect interest rates to fall, even though they are currently relatively high.
This means that mortgages created today will not last long and paying a premium on them does not make sense if they are paid off months later.
To alleviate this concern, lenders can reinstate prepayment penalties and lower mortgage rates in the process. This rate may reach 6.5% instead of 7%.
Ultimately, the borrower will receive a lower interest rate, and this will also reduce the likelihood of early repayment.
Both because of the penalty imposed and because the interest rate will be lower, making refinancing less likely unless rates fall further.
Of course, it must be implemented responsibly, perhaps only offered for the first year of the loan, perhaps two years, to avoid falling into a trap for homeowners again.
But this could be one way to give lenders and investors in mortgage securities some assurance and borrowers a slightly better interest rate.
Before creating this site, I worked as an account executive for a wholesale mortgage lender in Los Angeles. My work experience in the early 2000s inspired me to start writing about mortgages 18 years ago to help potential (and current) homebuyers better navigate the home loan process. Follow me on Twitter for hot takes.
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