In the financial world, there's usually a catch when it comes to a great deal. Subprime mortgages are a great example. These loans, with low-interest introductory rates, have a major catch: prepayment penalties.

If you took the time to read all the documents that you sign during a loan closing, the process would take weeks, not hours. These days, people with subprime mortgages wish that they would have taken all that time-and more-to have read the fine print about their loan's prepayment penalties.

Lenders commonly use these with high-risk, subprime mortgages. The penalties-the nature of which may not have been explained to borrowers at the time of closing-have been a major reason why so many homeowners are defaulting on their mortgages.

Profiting from a penalty


A prepayment penalty is a fee that must be paid by the borrower if he refinances his loan. They're commonly used with adjustable-rate mortgages, as lenders intend to prevent homeowners from refinancing when their loan's introductory interest rate ends. The rate adjusts upward at that point, causing the mortgage payment to skyrocket, earning the creditor higher fees.

If lenders allowed these loans to be refinanced without a prepayment penalty, they wouldn't recoup their costs. They offer these subprime loans at an extremely low introductory rate with the hopes that, when the rate adjusts, they can profit from either the new payment, or the prepayment fee.

Most borrowers don't focus on the penalties until it's too late. Whether they were keeping their eye on the short-term benefits of the loan, or were misled by an unscrupulous lender, borrowers often can't handle an uptick of two or three interest rate points on their mortgage payments. If they don't have the cash flow to handle the increased monthly mortgage, they can find themselves in deep financial trouble.

Caught in a depreciating crossfire


The recent decline in home values has complicated the issue. Many subprime adjustable-rate mortgages are at an extremely high loan-to-value ratio. When homeowners borrowed the money, they assumed that the real estate market would continue to see the double-digit increases of the past. Eventually, they assumed that they could use their increased equity to refinance their mortgages.

Slumping home values has made these mortgage refinances impossible. A mortgage that was leveraged to the hilt three years ago simply won't be rewritten if its home's value has decreased. As a result, subprime borrowers are locked into the loans.

Some have the means to wait out the prepayment penalty. Some do not. Either way, the higher rates will have a profound impact on their monthly finances.

Prepayment penalties are playing a large part in the subprime loan crisis. However, the blame shouldn't fall entirely on the lenders who created the fees. Consumers need to take responsibility for their own actions. Not only should they be careful not to borrow too much of their equity, but they should pay close attention to the specifics of their loans-especially the potentially back-breaking prepayment fee.

Published on November 15, 2007