NEW YORK -- Financial reporters learn to believe in reincarnation. No idea truly dies. All things come back in another form. Following that rule, some of the big banks and S&Ls have reinvented the mortgage prepayment penalty.
Many years ago, these penalties tied up almost every mortgage loan. You were charged a fee for repaying the loan before a certain number of years had passed.
Consumers revolted against the practice. About 14 states banned prepayment penalties, in whole or in part; another 13 put limits on them. In the remaining states, lenders dropped them voluntarily.
But now, prepayment penalties are coming back, and this time they're a choice, not a mandate. In fact, they're constructed in a way that some borrowers find appealing. If consumer acceptance grows, some states might reconsider their bans.
The new wrinkle is this: When you accept a prepayment penalty, the lender gives you a break on the price. You might get a lower interest rate. You might not have to pay points or some of the bank's upfront closing fees (a point is 1 percent of the loan amount).
Prepayment penalties usually apply only to adjustable-rate mortgages (ARMs), not to fixed-rate loans. You're penalized for prepayments within the first three to five years. After that, you can pay or refinance at will.
This deal should appeal to borrowers who: (1) are cash-poor and want a loan that costs less upfront; (2) will stay in their homes for at least three years; (3) don't expect mortgage interest rates to decline substantially (if rates do drop, refinancing might have saved you money); and (4) can't find a cheap mortgage from one of the many lenders with no prepayment penalties.
Why have some lenders brought back prepayment penalties? To counter the refinancing boom. As interest rates fell in recent years, borrowers by the thousands paid off their old loans by taking new and lower-rate loans. Some borrowers have refinanced their mortgages three or four times. With a no-point loan, it can pay to refinance if interest rates drop 1 percent or even less.
Lenders say they lose money on loans that are prepaid too soon. They need to hold an ARM for at least three years to earn a profit -- especially if the borrower paid no upfront points or got a super-low first-year rate. Borrowers tend to bolt from ARMs as soon as that sweetheart rate expires. Prepayment penalties lock them in.
Here's one way the deal can work at the Bank of America and BankAmerica Mortgage, both headquartered in San Francisco.
A no-point, 30-year $100,000 ARM carries a 7.125 percent rate of interest and $653 in certain bank fees (application fee, appraisal fee and so on). If you accept a prepayment penalty, however, you'll pay 6.125 percent interest and can skip the $653 in costs (although a few other costs apply).
You're allowed to prepay up to 20 percent of the principal each year -- so you still can accelerate your monthly payment schedule. But if you prepay more than 20 percent, you're charged 2 percent of the excess. Your potential penalty in the first year: 2 percent of $80,000 or $1,600. About 70 percent of the bank's ARM volume so far this year includes a prepayment penalty, reports spokesman Richard Beebe.
Great Western Bank, headquartered in Chatsworth, Calif., levies a three-year prepayment penalty on anyone who pays an upfront fee of less than 0.5 percent. You're free to prepay up to 20 percent a year. But there's a six-month interest penalty on the excess, says Senior Vice President Sam Lyons.
Home Savings of America, based in Irwindale, Calif., penalizes everyone who pays less than one point upfront and it structures its penalty differently. All prepayments are penalized, at the rate of 2 percent the first year, 1.5 percent the second year and 1 percent the third year. If you pay off your $100,000 loan after the first year, you'll owe $2,020, spokeswoman Samantha Davies says. About half of Home Savings' ARM borrowers are currently choosing the prepay.
Is this kind of mortgage for you? Maybe yes, if it lowers the cash cost of buying the house you want. But shop around before accepting it. Most banks don't levy this penalty, including Countrywide Funding, the nation's largest mortgage lender. You always have more options if you can prepay, cost free, anytime you want.
You can write to Jane Bryant Quinn at: Newsweek, 444 Madison Ave., 18th floor, New York, N.Y. 10022.