Prepayment penalties are among the lending practices targeted in the financial overhaul bill currently being discussed in Congress. The current version of the bill would altogether prohibit prepayment penalties for certain types of mortgages, including:

• adjustable rate mortgages (ARMs);
• subprime mortgages;
• negatively amortizing mortgages; and
• higher-priced mortgages (mortgages with rates exceeding a set threshold).

For all other loans, such as the standard 30-year fixed rate mortgage (FRM), prepayment penalties would be limited to three years, with the amount of the penalty not to exceed:

• three percent of the outstanding balance of the loan during the first year after the closing date of the loan;
• two percent of the outstanding balance of the loan during the second year after the closing date of the loan; and
• one percent of the outstanding balance of the loan during the third year after the closing date of the loan.

Under the existing bill, lenders would be prohibited from incentivizing the use of prepayment penalties and mortgages with higher interest rates.

The existing bill would further prohibit lenders from making loans without verifying a borrower’s ability to repay the loan, known in real estate parlance as liar loans or no-doc loans.­­­­­­

The House version of the bill requires lenders to keep at least a 5% stake in all mortgages originated until they are paid off, while the Senate version of the bill contains provisions requiring lenders to keep at least 5% of the securitized mortgages they sell in the secondary market on their own books. [For more information on this requirement, see the May 2010 first tuesday article, The era of reform: new regulations for bankers creating mortgage-backed securities.]

These proposals are intended to curb the lopsided financial dealings which ran rampant during the Millennium Boom, such as the practice of mortgage loan brokers placing homebuyers in mortgage loans with higher interest rates or borrower-costly, lender-friendly provisions (such as the prepayment penalty) in order to collect a premium from the lender since the loans were sold to lenders at par rates.

The bill is scheduled to complete its route through Congress by summer of 2010, at which time it will be placed before the president for final ratification.

first tuesday take: Curbing in any part the loose regulation that spurred the Millennium Boom will help to create a better and more stable real estate market, both for California and the nation. Critics of the regulation are crying out loudly (carrying their big lobbyist sticks and bags of money) that all of this regulation will stifle the flow of money, and first tuesday says, “EXACTLY.” Too-loose lending requirements are dangerous; they sow the seeds of destabilization in our California real estate market.

We would have preferred to see the prepayment penalties stricken altogether as a needless lender restriction of an owner’s property, however this modest proposal does well in prohibiting prepayment penalties on the least stable and most damaging of the mortgage products, the ARMs. [For more information on first tuesday recommendations for a stable real estate market, see first tuesday's Recommended Legislation.]

Will these provisions make it through the lobbyist-laden halls of Congress with these consumer protection provisions intact?  We’ll keep our fingers crossed. The next act of Congress must be to completely free the property owner to sell his own property without lenders unreasonably withholding consent on an assumption, a due-on issue that has plagued the free movement of property in California for too long.

Re: “Senate, House financial overhaul targets lending practices of the mortgage crisis” from the Washington Post

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Tagged as: Congress, lenders, prepayment penalties, regulation