Prepayment Penalties

The NYT's Geraldine Fabrikant reports today on moves to abolish prepayment penalties in the mortgage market. I think this is a good idea, although it would have been a much better idea a few years ago, when loans with teaser rates and high prepayment penalties started fuelling the housing bubble.

As with much of the US financial system, a lot of the problem is regulatory: prepayment penalties are banned on a state-by-state basis, which means that anybody can impose a prepayment penalty in any state if they're a mortgage company or a national bank and therefore not subject to state supervision.

I can only really think of one conceivable justification for prepayment penalties. Buying a house entails a lot of expenses, over and above the cost of the house: moving, furnishing, buying appliances, and so on and so forth. Many of those expenses are not up-front, necessarily, but continue for a year or so after the home has been bought. And so a low initial interest rate, or teaser rate, can help the new homeowner cover those extraordinary initial expenses; when the rate resets to a higher level, the homeowner should have got over that difficult hump and be in a better position to make the full mortgage payments.

But of course in practice mortgages were sold almost entirely on the low level of the teaser rate. It wasn't presented as a temporary discount on the eventual interest rate; it was presented rather as the monthly cost of the new loan – with the higher eventual cost being played down as much as possible by lenders keen to originate as many mortgages as possible.

Besides, there are other ways to help homeowners deal with unusually high expenses in the first year or so beyond teaser rates and prepayment penalties. A simple second-lien loan is one, or even a first-lien loan: the homeowner can just borrow more up-front and use that money on things like appliances.

Tanta, for once, has some good news: the prepayment penalty, in its most egregious form as detailed by Fabrikant, is already dead, killed off by the Fed's new Nontraditional Mortgage Guidance. So even if Dodd's bill doesn't go through, the worst-offending products are almost certainly behind us at this point.