FHA mortgages have always been distinguished by the fact that they do not have fees called prepayment penalties, unless you count the post-settlement interest charges shelled out by FHA borrowers who pay off their loans early. Those charges -- prepayment penalties by another name -- cost borrowers $449 million just in 2012.
Now HUD is now proposing an end to post-settlement interest charges, an end which is long overdue.
So what is a prepayment penalty and how does it differ -- if at all -- from a post-settlement interest charge?
When lenders make a mortgage they incur a variety of costs which are only recaptured over time. To protect themselves, lenders want a way to assure that they do not face losses if a loan is quickly repaid, thus the basic justification for prepayment penalties.
FHA Mortgages and Prepayment Penalties
The catch is that prepayment penalties evolved into profit centers during the go-go lending years between 2000 and 2006. Borrowers could get mortgages with little money down and little documentation, but if the mortgage was paid off during the first three to five years of the loan term, many sub-prime, Alt-A and other lenders would be owed a prepayment penalty based on a number of months' interest (usually six), or a percentage of the loan balance (usually two percent but sometimes three, four or even five percent). If the balance was, say $250,000, then a borrower might need as much as $12,500 in cash to exit the loan. Since many borrowers did not have such cash, they were effectively forced to continue mortgages with high-cost financing when loans with better mortgage rates were readily available.
To make matters worse, prepayment fees not only prevented refinancing to a lower rate, they also blocked many owners from selling. If a borrower got a new job in another state and wanted to sell that decision could become very costly because an early termination of the loan for any reason meant that the prepayment penalty could kick in. (Note: Not all prepayment penalties apply if the house is sold. Some, called "soft" prepayment penalties, only kick in if the loan is refinanced.)
Under Dodd-Frank and Wall Street reform, there are a number of rules which protect borrowers from predatory loans. In basic terms, only qualified mortgages or QMs can have prepayment penalties. When there is a prepayment penalty -- and remember that qualified mortgages such as VA financing, FHA mortgages and conventional loans sold to Fannie Mae and Freddie Mac do not allow such fees -- the amount of the charge is limited to three percent the first year, two percent the second year and one percent the third year. After that, no prepayment penalties are allowed.
FHA Mortgages and Post-Settlement Interest Charges
To it's credit, FHA loans have never had anything called prepayment penalties. What they have had are onerous post-settlement interest charges.
If you pay off most loans on the 5th of the month, your interest fees also end on the 5th for the very-obvious reason that you no longer have use of the repaid funds. With the FHA, however, there is that post-settlement interest charge. This means if you pay off your loan on the 5th you must pay interest on the loan until the end of the month -- even though you cannot use the money.
"This is an issue of fairness," said Senator Ben Cardin (D-MD) in 2011. "Homeowners should not have to pay interest on loans that have been fully repaid."
"Given the variety of factors that contribute to the closing date on a loan, many of which are beyond the control of the borrower, such a requirement is an unreasonable and often unexpected burden," according to the National Association of Realtors. "In 2003, for example, FHA’s data indicates that FHA borrowers paid more than $587 million in excess interest fees as a result of this onerous requirement in that year alone."
Post-settlement interest charges have long been a huge source of irritation and unfairness for several reasons. First, borrowers are paying interest on money which is not outstanding. Second, while post-settlement interest charges have long been required by FHA rules, it is not the FHA which gets the money; it's lenders. Third, post-settlement interest charges allow lenders to double dip because they're getting interest from FHA borrowers for funds that can be loaned out to someone else at the same time.
With new rules limiting prepayment penalties developed by the Consumer Financial Protection Bureau coming into play, HUD is aligning its closing cost requirements to meet the standards created by Dodd-Frank. That's good for borrowers, to the tune of roughly half-a-billion dollars a year.