This article addresses avoiding prepayment penalties by submitting an application for a loan assumption on a cash-to-new-loan sale.
Historically, lenders have employed prepayment penalties as a means to prevent the loss of interest during the period following the principal payoff until the funds are re-lent to another borrower. In addition to serving as a backstop for lost interest on money lent, lenders also treat prepayment penalties as a means of recouping administrative costs and padding income by prepaid interest after receiving a principal payoff.
California courts view prepayment penalties as a right lenders may contract for. For instance, the prepayment charge provision was held not to be punitive in nature, but a form of compensation for interest the lender lost through prepayment, agreed to by the borrower in the trust deed note. [Ridgley v. Topa Thrift and Loan Association (1998) 17 Cal.4th 970]
Another rationale holds the prepayment penalty helps mitigate loss of lender profitability, and views the prepayment penalty as necessary to enable lenders to maintain their loan portfolio yield. Consistent profitability is a crucial component for a lending institution to appear healthy. Thus, courts have neglected the good faith of borrowers who wish to rid themselves of debt, reasoning prepayments of principal disrupt a lender’s long-term expectation from invested funds. [Lazzareschi Investment Company v. San Francisco Federal Savings and Loan Association (1971) 22 CA3d 303]
Thus, with judicial backing, lenders build the prepayment penalty fee into the trust deed note as a prepayment of principal provision, which borrowers agree to upon signing. The inclusion of a prepayment penalty provision in the note and the consequences of the penalty should be pointed out to buyers by their agent.
Both California and the federal mortgage law place a five-year limit on the duration of prepayment penalties. During the five-year period, the payment of even one cent more than 20% of the original principal loan amount in any twelve-month period allows the lender who has contracted for it to receive up to six months of unearned interest on the prepaid principal exceeding the 20% figure. [Calif. Civil Code 2954.9(b); 12 Code of Federal Regulations §591.5; see first tuesday Form 418-2]
Most homeowners who entered into a mortgage during the past five years have a prepayment penalty clause folded into the note secured by the home. Likewise, many loans secured by single family residences (SFRs) were sold into the secondary money market and do not contain prepayment penaltyclauses. Freddie Mac, the primary purchaser of securitized SFR loans sold in the secondary money market, has a policy of not charging prepayment penalty fees if doing so will hurt the consumer.
Nevertheless, consider the homeowner who has a positive equity and finds a cash-to-new-loan buyer. Is there a way for the homeowner to avoid paying prepayment fees when paying off the existing mortgage?
Yes! If the homeowner locates a cash buyer (or cash-to-new-loan buyer) who agrees to initiate an assumption of the seller’s loan, the assumption approval process could prove to be a stumbling block for the existing lender’s ability to recoup a prepayment fee when the loan is actually paid off at closing. Federal law bars the lender from imposing a prepayment penalty if the existing lender fails to approve the buyer’s application to assume a loan within 30 days after receiving the request. The seller then has 120 days in which to pay off the note (with funds obtained from the sale to the buyer) without incurring a prepayment penalty. [12 CFR §591.5]
Bear in mind, the lender’s process of approving an assumption typically requires more than 30 days. Until 2012, most lenders will be so busy processing foreclosures and fielding (read: denying) modification requests, few able to promptly process a loan assumption. Thus, a window of opportunity now exists for sellers to avoid a prepayment penalty fee on a loan payoff by providing for the buyer to submit a loan assumption request while at the same time locating a new loan to purchase the property. The purchase agreement would be written up for the price to be paid in part by an assumption of the loan (or a new loan at the buyer’s option) at the time of closing. The buyer would also agree in the purchase agreement to promptly apply for, and cooperate in, the loan assumption process.
But before working up the deal, inquire into whether the seller’s loan is insured by Fannie Mae, the Federal Housing Administration (FHA) or the Veterans Administration (VA). Fannie Mae rarely enforces prepayment penalty provisions on conventional loans secured by SFRs. However, prepayment of adjustable rate mortgages (ARMs) or second mortgages usually incur prepayment penalty fees from Fannie Mae. Neither FHA nor VA charge prepayment penalty fees on early payoffs. Rather, both charge a maximum of one month of unearned interest—a tiny amount when compared to the common terms of a prepayment amount, which call for six months of unearned interest.