Refinancing With a Prepayment Penalty

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how soon should I start shopping around to refinance my home? I have a 2yr interest only and it's up in (four months)

Okay, the 2/28 loans which you are describing all have prepayment penalties for at least two years. Figure it's going to cost you 6 months worth of interest, on top of the cost of the refinance, if you refinance before the penalty expires.

(OK, you could have specifically bought it off by accepting a higher rate, but that's unlikely to have been the case)

That said, about three weeks before the penalty expires you can start the refinance process. Be advised that until the day the penalty expires, the current lender will be quoting a higher payoff, but once it has actually expired, the payoff should be correct, at least in theory. You should not sign final loan documents until such time as your penalty will expire with or prior to your Right of Rescission expiring. No more than two to three days prior to expiration.

Indeed, sometimes lenders will want to keep charging penalties even after they're no longer due. I'm not certain if they just don't update the payoff correctly or what, but I've seen lenders try to charge penalties a month after they expired. Once they've got your money, they can make you pay a lawyer and go to court to get it back.

For this reason, I would avoid "cash out" refinances any time within three months after the penalty expires. Matter of fact, if you're refinancing during that period, not only don't refinance for cash out, but don't have an impound account for taxes and insurance, and don't plan to put any money at all into the loan balance if you can avoid it. Here's why: When escrow officer goes to request a payoff from the soon to be former lender, the payoff quote may include the penalty even if it's no longer due. if they money they have from the current lender covers the whole thing, they have two choices. Pay it and have a completed transaction (not to mention getting their company paid), or don't, and leave everybody hanging. If they pay it, this means that you, the consumer, only get a much smaller amount of money, but I'm disgusted at how often consumers are shorted by the loan process, and this is one more way it happens. You're expecting $20,000 cash, and that $20,000 was the entire reason you did the loan. Comes the proceeds check, and you've only got a check for $9000. You want the other $11,000, you're going to have to go through the whole process again. Not the kind of situation you want to be in. Not the kind of situation I want my clients to be in.

If, however, the escrow officer does not have enough money available to them to pay off the loan plus the penalty, they have no choice but to leave the transaction at that stage until the quote is correct. They won't let it sit - they'll find out what's going on and everybody involved will be doing what's necessary to resolve the conflict between the two issues. Not having any more money in the loan than necessary to pay off the old loan is a good way to insure that the escrow officer won't pay a penalty you don't owe.

Don't let the rush to pay off the old loan cause you to cut corners on either your shopping for a new loan or asking all the questions you should ask prospective loan providers. Rushing into a refinance because your loan is going to readjust is one of the best ways to waste large amounts of money that there is. To illustrate, let's look at a larger than average loan amount that sees a huge jump in the actual rate. $400,000 at 6%, and it goes to 9%. This makes a difference of $33.33 per day, or $1000 per entire month. That's the equivalent of a quarter point on the cost - basically nothing on the scale of differences between subprime loans, and not very much on the scale of differences between A paper loans. I'll usually beat the retail branch of the lender I place a loan with by at least twice that. If it makes a difference of 0.25%% on the rate, that's $1000 per year that you're going to be stuck with the new loan. If you're still a subprime borrower, multiply that by the length of your new prepayment penalty in years. Doesn't it sound worthwhile to take an extra day which your old lender bills you $33 extra for, to shop the loan around for real and ask the hard questions that enable you to save $2000 or more on the new loan. Even if you're putting the money into your balance, you're still paying the extra. Not only that, but you're paying interest on it as well. On the scale of costs for a new loan, paying the soon to be former lender for a few more days at the increased cost is likely to be a wonderful investment if it gives you the opportunity to find a better loan.

On a note of personal relevance, at the time this is written rates are higher than they were two years ago, and you're in an interest only loan now, while interest only loans are difficult to do right now. Your payment is probably going to end up higher, especially if you roll loans costs in. If the reason you were in an interest only loan was that your debt to income ratio couldn't qualify for the real payment on a sustainable loan, that refinance is probably not going to happen for you. With prices having decreased locally by 25 to 30 percent, your loan to value ratio may not support refinancing either. If a refinance is not going to happen, and you can't afford your current payment, it's time to sell now. The new FHA Secure program helps some people, but requires documenting enough income to afford all of your payments. You owe what you owe and the rates are the rates. If the numbers don't work, get it sold.

One more piece of advice: Start improving your credit score now. Four months is plenty of time to bring your credit score up fifty points or more. If you can get into "A paper" loan territory, where penalties are much less common, you'll be much happier with your new loan than you are with this one. If you're in subprime territory and able to improve your loan to an "A paper" loan, your rate may go down despite the fact that the rates are higher.

As I cover in Getting Out of Paying Pre-Payment Penalties, if you're willing to refinance with the current lender, either directly or through a loan broker, your lender may be willing to waive the penalty in favor of sticking you for a brand new prepayment penalty on a larger amount. This is usually making a bad situation worse. As I said, you're likely to get a higher rate, be limited to an amortized payment on the new loan, and the new loan amount is likely to be higher (people in the situation usually roll the costs in), and all without even the benefit or lowering the tradeoff between rate and cost like penalties usually do. This seems pretty much the definition of lose-lose-lose-lose to me. Longer prepayment penalty on a higher balance at a higher rate, without getting any benefits in exchange. This is kind of why the best way to deal with prepayment penalties is not to accept them in the first place.

Caveat Emptor

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This page contains a single entry by Dan Melson published on March 13, 2008 7:00 AM.

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