A penalty that applies to refinancing only is a soft penalty; a penalty that applies to both refinancing and a home sale is a hard penalty.

If your credit score is not very good, I am afraid, you don’t have very much of a choice here. You are forced to do whatever your lender tells you to in order to get the loan. However, try as hard as you can to avoid the hard penalty . Borrowers with a good credit, though, can try to profit from letting a prepayment penalty into their contract. The lender must agree to a lower rate – about one eighth to three eighths of a point below the market rate. It is strongly recommended for a borrower to avoid the hard version of the penalty at all times! However, the profit may turn out quite doubtful if the rates drop within the penalty period but the penalty will make refinancing too costly. It is a sort of gamble. Maybe buying points is a better option for borrowers with a good credit score.

A prepayment penalty is the jack-in-the-box of the mortgaging world. Most times it is equally annoyingly unexpected (for the borrower), but unlike the dumb toy, it may cause people to lose their money, not just make them produce a polite squeak of a laugh.

A prepayment penalty, if included into a mortgage contract, states that the borrower shall be penalized for a fast repayment of the outstanding balance, a too fast one, that is. What’s too fast? The Note of your mortgage contract contains a schedule of your repayment. Any extra payment ahead of this schedule accelerates the complete repayment of your loan. It saves you quite some money on the interest, but, weird as it may seem, does not make the lender particularly happy. The lender does not want you to get away so soon and easy, he wants you to pay as much interest on the money you’ve borrowed as possible. So, he tries to impose a penalty on you, forcing you to keep your mortgage unchanged for at least 3 or 5 years. It does not mean that extra payments are totally forbidden during this period, but they will probably be limited to the maximum of 20% of the original loan’s balance per year. Everything above that amount is penalized. 

Now, why is it a jack-in-the-box, if everything is so obvious? The problem is that the clause actually containing the penalty statement is presented to the borrower in a very confusing form, which results in a lot of people being totally unaware that they are subject to a prepayment penalty until they actually face it. Namely, a standard mortgage contract will have a Truth in Lending Disclosure Statement attached. A standard Truth in Lending Disclosure Statement closes with the paragraph:

PREPAYMENT:
If you prepay this loan in full or in part, you
◊ may                ◊ will not have to pay a penalty.
◊ may                ◊ will not be entitled to a refund of part of the finance charge.

The word “may” is totally misleading here. Normally it would suggest, that the penalty either does or does not get to be applied depending on the circumstances. In this context, however, the meaning of “may” is actually “will”, as opposed to “will not”. That’s where the confusion lies. Seeing the “may” box ticked, a lot of people get a wrong idea that the possibility of a penalty remains subject to discussion, should the relevant circumstances occur.

As a result, if, for example, the rates drop during the earliest years of a mortgage and the borrower wishes to refinance, he may be unpleasantly surprised to find out, that the refinancing will be a penalty more expensive. How much more – depends on the contract. The amount of the penalty can be a fixed amount (an equivalent of six months of interest, for instance), or a percentage of the outstanding balance, fixed or regressive. For example, the penalty for prepaying a mortgage in its first year may be 5% of the original balance, in the second year – 4%, in the third year – 3% etc.

A penalty that applies to refinancing only is a soft penalty; if it also applies to a home sale – it is a hard penalty. If there is a penalty attached to your contract – make sure you know exactly which kind it is.

A prepayment penalty is not a must in every contract, though. If you are certain that you don’t want any penalties of this sort to be included, make it clear to the lender/broker and check the mentioned above paragraph of the Truth in Lending Disclosure Statement explicitly to make sure that nobody misinterprets your point of view, or when signing just ask, “Show me where it says there is no prepayment penalty,” or “Show me the terms of the prepayment penalty.” If you don’t bring up the subject yourself, you may see the “may” box ticked anyway, sort of “by default”, in the hope that you won’t notice. I hear lots of stories of lenders slipping in seemingly little details, like the little ticked box mentioned above, into contracts just before signing in the hope that the borrower will not care to read everything thoroughly. This rather dirty trick works on so many people, that it is scary.

Why would lenders go into all this trouble to get the penalty included? But for the primary reason – getting as much money from you as possible even if you keep the mortgage for a short period of time, there is another quite pragmatic reason: it makes your mortgage worth around 1% more in the secondary market. It’s all about money, gentlemen. That’s why all the pleads of desperate confused borrowers for a waiver of the prepayment penalty usually fall on deaf ears.

Generally, a prepayment penalty cannot be imposed on you, unless you have a very poor credit score. Borrowers with a good credit score can actually benefit from allowing a prepayment penalty into the contract. A lender must agree to a lower rate – about one eighth to three eighths of a point below the market rate – if such a borrower agrees to have a prepayment penalty included into his contract. It is strongly recommended for a borrower to avoid the hard version of the penalty at all times! However, the profit may turn out quite doubtful if the rates drop within the penalty period but the penalty will make refinancing too costly. It is a sort of gamble. Maybe buying points is a better option for borrowers with a good credit score.

A prepayment penalty is not a permanent provision of a mortgage. It usually applies to the first 3 to 5 years of a mortgage. After that the borrower is free to pay the loan off as fast as he wishes to without any penalties.

This very unpleasant situation does require a considerable financial effort on your part, but it can be resolved eventually to your advantage. The two most reliable ways are: to make extra payments towards the Principal, or/and refinance into a Fixed Rate Mortgage.

How do extra payments help? The amount paid as Interest is a percentage of the outstanding balance (the principal part). The lower the balance – the lower the absolute interest payment. If your mortgage carries no principal prepayment penalties, you can pay some extra cash towards the principal. It may keep the absolute sum of your monthly interest payment close to intact on the one hand, and it will accelerate the overall payoff of the mortgage on the other. So none of your money will be wasted, but you may have to tighten your belt for a while.

Refinancing into a Fixed Rate Mortgage is not cheap either, so before you decide to turn to the stability of a fixed rate, analyze your current mortgage – make sure the change is worth it. Points to consider:

• a convertible loan feature that allows for an easier conversion of an Adjustable Rate Mortgage into a Fixed Rate Mortgage may already be included into your current contract.
• Compare the cost of refinancing with the gain on the saved interest.
• Your current adjustable rate mortgage very likely carries all kinds of caps. You have to see how they limit the rate and how much higher it can possibly get. It may well so happen that your highest rate will still be lower than the fixed rate.
• Watch out for the Payment Cap as the rates rise! Make sure it is not amortizing your mortgage negatively! If it is – refinance immediately into anything you can afford, before it brings your current balance to the size far beyond your financial potential!

Today I suggest we talk about the so-called “no-cost” refinancing. First of all, this commonly used name for a refinancing option one can find very useful under certain circumstances is in fact rather misleading, because:

• No-cost does not mean free from any costs;
• No-cost refinancing helps you only with the Non-Recurring Closing Costs;
• No-cost refinancing still leaves you to pay at least Property Taxes, Interest, and Insurance.

Now that you’ve been warned, let’s take a closer look and find out about the circumstances under which this option can be useful.

Any refinancing involves a number of fees charged by both the lender and third parties. The fees are rather numerous and can add up to quite a considerable amount. You can either pay it all yourself or opt for the “no-cost” alternative. In the latter case, the lender will pay most of the refinancing fees at the moment of the refinancing itself, but it is going to cost you a higher interest rate on your new loan. The interest rate on a loan resulting from no-cost refinancing is usually 0.250% – 0.500% higher than that on an equivalent borrower-paid-closing-fees loan. This is the lender’s way to return the money he actually lent (not gave!) you by paying the refinancing costs: he just bought you some negative points. The rate will be high enough for the lender to be able to recover the complete amount. The new loan may include prepayment penalties, as the lender wants to make sure, the money does get to be repaid. A true no-cost refinancing employs only the interest rate to return the money. Unlike a “no-cash” mortgage closing option, there should be no increase in the total amount borrowed on that account. It is very important to make sure that both you and the lender have a clear and agreed upon idea of how the refinancing fees are going to be repaid.

Even though you are the one to pay all the costs after all, I dare remind you, the lender’s one-time helping hand contribution at the refinancing will not cover all the settlement fees. Very likely, it will only take care of the non-recurring closing costs, such as the appraisal fee, the credit report, the lenders’ fees, the broker fees, the title insurance, the escrow fees and the recording fees. The non-recurring refinancing costs, such as the property and transfer taxes, the interest (the new loan’s interest from the day of closing to the first day of the following month and the interest on your old mortgage from the first of the month to the closing day), and homeowners insurance are still totally your responsibility.

The most important thing is to be aware that even no-cost refinancing calls for quite some of your cash anyway and results in a higher interest rate loan. Considering all this, I still believe that this type of refinancing can be much of assistance to borrowers who are willing to get rid of their current loan for some reason, but are short of cash to pay all the refinancing fees themselves. It’s true that they will need to invest some of their own funds into the process, but the amount will be considerably lower than the complete settlement costs.

The resulting high interest rate is a bit of a pain, though, as the monthly payments are higher, but it takes a while (the breakeven period) before it really starts eating your money. It is easy to estimate roughly how long this while will be in your particular case: look at the difference in your monthly payment for a no-cost loan vs. a loan with costs and then divide that difference into the amount of non-recurring closing costs that you would have to pay at closing.  The result of this calculation is the number of months, during which the no-cost refinance loan is a sensible deal. If you have to keep this mortgage longer, it turns into a rather costly deal.

For that matter, no-cost refinancing is generally useful to people, who are not planning to stay in this particular mortgaged property for a period of time longer than the above mentioned break-even period.

Finally, if your fortune changes and instead of being short of cash you suddenly happen to have plenty of it, you can try to refinance again and attain more reasonable conditions. Mind the new refinancing costs and the possible prepayment penalties, though.