Prepayment penalties were sometimes useful

Before the financial crisis, many mortgage contracts contained provisions stating that borrowers paying off their loans early had to pay penalties, usually expressed as a percent of the outstanding balance at prepayment or a specified number of months of interest.

In most cases, the penalty declined over time. Partial prepayments of up to 20 percent of the balance usually were allowed in any year without penalty. Sometimes, the penalty applied to a home purchase, but more commonly it applied only to a refinance.

Prepayment penalties were never allowed on FHA or VA loans, but after the crisis Fannie Mae and Freddie Mac also barred them. Today, they are permitted only in the sliver of the market not touched by the federal agencies.

Many say good riddance. I view it as the loss of an option some borrowers could find useful.

Here's a letter I received before the crisis: "We are committing ourselves up to the limit of our capacity to buy the house we want. Our broker said we could reduce the rate from 7 percent to 6.75 percent if we accepted a prepayment penalty. This would reduce our payment by $35 a month, which would help a lot. Should we?"

This offer was typical for that time. Lenders, and the investors who purchased loans in the secondary market, were willing to accept a lower rate in exchange for a prepayment penalty. The benefit to them was that it discouraged refinancing if interest rates fell. The borrower received the immediate and concrete benefit of a lower rate and freely gave up the right to refinance.

But the penalties were widely used in connection with subprime mortgages, with the resulting post-crisis guilt by association.

Here is another pre-crisis letter: "Because I have very bad credit, I agreed to pay 11 percent for a 30-year mortgage. Friends have warned me to avoid a prepayment penalty, but when I ask the loan officer about this, he says that the lender absolutely requires it. Do I have any options?"

At the time, I advised this writer he might be able to negotiate a less burdensome penalty clause but would not be able to rid himself of it entirely.

Lenders generally demanded prepayment penalties on subprime loans because the risk of refinancing was so high.

Because of high origination costs and high default costs, subprime lending was not profitable if the good loans walked out the door after only two years.

The subprime experience might not have had the impact it did if the practice of offering a prepayment option on prime loans also had been widespread, but it was not.

Some prime borrowers, however, did find themselves with prepayment penalties for which they had received no compensation, despite the fact that the mandatory Truth in Lending form received by every borrower addressed them. The disclosure was so ambiguously worded that many borrowers who read it missed the point.

So a sometimes-helpful option was used by some lenders to abuse some borrowers. Regulators failed to curb those abuses through mandatory disclosures or other devices. Thus, the regulators eliminated the option.

In my view, this is regulatory failure.

Jack Guttentag is professor emeritus of finance at the Wharton School. http://www.mtgprofessor.com.