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Option Arm Prepayment Penalties

Option Arm Prepayment Penalties are often "required" by both lenders and brokers who originate this type of loan and are often not disclosed at application or are very poorly disclosed while the loan is in process. I have heard entirely too many stories about people getting to closing only to discover their loan has a long prepayment penalty when it is too late to do anything about it. As a broker who does a lot of these loans, I want to make sure you know what they are and how to minimize their impact.

Option Arm prepayment penalties are assessed and added to your loan balance when your loan is paid off in full or if your loan balance is reduced by 20% or more in one year. There are two types of prepayment penalties in use today. First, is what is described as a "hard" prepayment penalty which is assessed if the loan is refinanced or the property is sold. Second, is described as a "soft" prepayment penalty and is assessed only when the loan is refinanced or the loan balance is reduced by more than 20%. If the property is sold, a prepayment penalty is not assessed. Unfortunately, Option Arms only are available with "hard" prepayment penalties in today's market.

Now, for the really bad news. While there are a very few states that control the amount a lender can charge for option arm prepayment penalties most lenders will charge you a whopping 3% of your loan balance when the loan is paid off prior to the expiration of the penalty period! For example, a $400,000 loan could cost $12,000 just in penalties to get out of. If you have the typical 3 year prepayment period, you are trapped until the prepayment period expires.

Why do lenders and brokers do this? In a nutshell, money. Lenders, in their defense, incur significant costs to create a mortgage and are counting on holding the loan for a period of time to recoup their cost. If you pay off early, they lose money. To give you an idea of the magnitude of the problem, quite a few years ago, I managed a "brick and mortar" mortgage operation. I took a very hard look at our costs and found that our fixed costs for every loan we originated was nearly $5,000 and that we had to hold the loan 2.25 years just to break even. To be fair, cost structures are better today but you can see the issue. Brokers are typically compensated by the lender for originating a loan and the broker's compensation is frequently tied to the length of the prepay period. An Option Arm without a prepayment period will net the broker little or no compensation (a tough way to stay in business) while one with a 3 year prepayment penalty will get the broker up to 3.5% of the loan amount in compensation.

How do you protect yourself? It is not good enough with this type of loan simply to ask for a Good Faith Estimate before you agree to the loan. The Good Faith does NOT disclose a prepayment penalties. Ask for a Truth in Lending statement and please, please talk to any loan originator about the prepayment penalty before you decide. You need to know the length and amount before you can make an informed decision.

As a broker specializing in this type of product, I have access to 38 different lenders offering a variation on this loan. All want prepayment penalties and some will refuse to fund the loan without them. However, all five of my primary lenders will allow me a great deal of latitude on how to handle the issue. With most loans (my own personal Option Arms as well) I will have a 1 year prepayment penalty. My thought is that I am reasonably confident I know where I will be in 1 year but if I try to look down the road 3 years the crystal ball gets really cloudy. If we have a client who knows they will not be in the loan for at least a year, my lenders will allow a complete buyout of the prepayment penalty for a charge of around 1/2 point depending on the lender. If we have a client who is absolutely sure they will be in the loan for a longer period, I will give them a credit of 1/2 point on their closing costs for a 2 year term and 1 point for a 3 year prepayment penalty but only after thoroughly discussing it with the client.

I hope this helps you to understand the ramifications of Option Arm Prepayment Penalties.

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