Consider this scenario.
Two years ago you, a self-employed California home owner with good credit, were talked into taking a neg-am adjustable rate mortgage for “the payment flexibility” by a slick-talking loan officer. In order to get a “no points, no fee” loan you took a 3-year hard prepayment penalty with the loan. That prepayment penalty isn’t up until some time late next year.
Your home is “worth” $550,000 right now, down from $600,000 a few short months ago, but there are homes on the market that have been sitting and you feel future price devaluations are imminent. You bought before the peak of the market and have 25% equity currently at $550,000.
You have no problem making the fully-amortized payment; but your Option ARM loan (scheduled to recast in 3 years) has an interest rate of nearly 8%; and with a 30-year fixed in the mid-5% range right now - it could save you some serious cash. The prepayment penalty is 2% of the loan amount - $11,000.
The Question: Do you eat your prepayment penalty?
Consider what happens if we wait it out. Home prices continue to decline - perhaps to the point of wiping out the remaining 25% of equity that currently exists in the home. Loan guidelines tighten up to the point where self-employed borrowers have a much harder time of qualifying for loans with underwriting guidelines that become more restricted as we move through this mortgage meltdown.
It is conceivable that by the time the prepayment penalty is up this borrower will have little to no options for refinancing.
In this case I think it makes sense to eat the $11,000. Particularly if the borrower is planning on staying in the home for a period of time that surpases the recast date of the Option ARM. Why? Because there is a very good likelihood of the following occurring:
- Foreclosure, short sale or further price cuts in the neighborhood wipe that $11,000 out quickly - no matter what the borrower does.
- Potential market declines could wipe out nearly the entire 25% of the borrower’s equity in 14-16 months.
- Banks eliminate or overly restrict program guidelines that make it difficult for self-employed borrowers to get financing when compared to today’s qualification guidelines.
- Interest rates begin to rise in the face of inflation making his Option ARM more expensive.
In this case I say the risks outweigh the rewards of sitting on the sidelines. You’re sitting on a mortgage that is expensive and fluctuating. Even though you can afford the payments at the near-8% rate you are risking losing your options once you come out of your prepayment penalty and may be stuck in that expensive loan for much longer than you initially planned on when you took it as a “short-term” flexibility option.
I’ve never been a fan of the ‘eat the prepayment penalty’ argument. I thought it was just a shameless way for LO’s to promote equity withdrawal and refi churn during the run-up. But now watching programs, values and lenders getting swept away by this mess gambling on what the future lending environment will look like in 16-24 months seems like a poor bet for someone who may find themselves on the outside of much tighter guidelines in the future.
What do you think? And are there other reasons why someone should pay the prepayment penalty now to get out of a loan?
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