The Home Loan Trap
Homeowners whose loan rates are soaring may want to head for the exits. Many of them may find no way out. If they sell their home or refinance, they will face a penalty of thousands of dollars for paying off their loans early. According to the Center for Responsible Lending, these exit fees, called prepayment penalties, were added to more than two-thirds of the adjustable-rate loans. Those loans initially carry a very low interest rate, known as a teaser because it is below the market rate and rises sharply over time. The lenders say the trade-off is the only way to offer low monthly payments initially because otherwise borrowers would flee when rates adjust upward and make the loan a losing deal. The fees usually equal several months’ interest, and they decline over a few years before disappearing altogether.
Homeowners often think they can keep up with their rising payments or that they will simply refinance later, but the penalties can dash that hope. State governments, regulators and members of Congress are considering whether to rein in prepayment penalties. Senator Christopher J. Dodd, Democrat of Connecticut, said this week that he would introduce legislation to eliminate the penalties and make other changes in home lending practices. When interest rates were high in the 1970s, states took steps to protect consumers from onerous prepayment penalties. Such fees generally disappeared from standard loans. In the late 1990s, though, subprime loans to people with weak credit blossomed, and with those loans came a resurgence in prepayment penalties. A number of states limit the penalties, but only state-regulated banks are generally subject to those restrictions; mortgage companies and national banks are not. Experts say that many borrowers do not really understand the implications of prepayment penalties (if they are aware they have them at all) and fall prey to sophisticated marketing.
In a 2002 lawsuit by the Association of Community Organizations for Reform Now (Acorn) on behalf of a group of borrowers against Household Finance, Acorn said that lenders referred to the practice as “closing the back door” by making it too costly for borrowers to get out of loans with rising rates. The art of finding borrowers was carefully honed, according to the lawsuit. Among the techniques was sending a check and telling recipients they could have access to a small loan by cashing it. Those who did went on a hot list of prospects in a strategy referred to as target practice, according to the suit.
A study by the Center for Responsible Lending shows that borrowers in minority neighborhoods received a disproportionate share of loans with prepayment penalties. The Pew Hispanic Center reported in 2002 that African-American families had a median net worth of just under $6,000. Hispanic families had nearly $8,000. For white Americans, the median net worth was $88,651.
