DJ,
I understand "prepayment clause" as the mortgagee's right to pay down on the principal under conditions to be agreed upon (max once a year, not more than x % of principal etc). In other words I dont get the meaning of "Lenders that insist upon the clause would find themselves at a competitive disadvantage with other lenders." Why would a lender insist?!
In the USA, a prepayment clause covers both the situation where a borrower prepays (a) portion(s) of the mortgage or the situation where the borrower simply retires the mortgage early by prepaying the principal in full. In years gone by, lenders would not permit prepaying the balance of the mortgage without imposing a penalty fee on the borrower for prepaying or retiring the mortgage. As time passed, the lending business changed, and more competition evolved. As a part of the competition, the prepayment penalties (or fees) were eliminated by the lenders themselves (for a good reason, which I'll explain later). Eventually, the entire clause was eliminated, save for one small part, that part being the agreed upon terminology as to how the lender will apply additional payments to the remaining mortgage balance in the situation where the mortgage is not paid in full. For example, you have a 30 year mortgage for $100,000 with a monthly payment of $1000. Each month you pay the lender the $1000 due plus an additional $100. The terms of how that additional $100 payment will be applied to the mortgage balance must be spelled out in the mortgage itself. In most cases the lender will either accumulate these payments in the escrow account and apply the excess once (or twice, whatever) per year, or (rarely) the lender will apply the additional payment as it is received. Any penalty fees (which used to be very common) are usually no longer found in most mortgages these days.
Some lenders might insist upon the old style of prepayment clause, whereby the borrower can be penalized for early payments or retiring the mortgage early. This is the type of lender that I would not do business with.
As far as why would any lender insist upon the old style clause... It would be because the lender can do so (potentially increases the lender's profits) in situations where the borrower might not be a good credit risk, and therefore the lender isn't worried about competitors, or the property itself might have some unusual risks involved.
What's their side of the story?
The lenders side of the story is quite simple. They attempt to maximize profits based upon the amount of the mortgage, the term (length) of the loan, the borrower's credit history and the value of the underlying asset for the mortgage. Whatever they can legally get away with, such as fees and charges, without becoming uncompetitive, is fair game and is expected by the borrower. That's why a borrower with a good credit history has a better bargaining position with the lender than someone with a poor credit history. Good borrowers can negotiate away virtually all of the extra fees, presuming of course that the lender actually wants to do business with a good credit risk.
Could it be that by accepting the prepayment clause you abrogate your right to terminate the contract at your convenience?
Exactly!
Okay, now let's look at the old style prepayment clause from the lender's perspective.
The old prepayment clause was typically found on mortgages that were taken out after the end of World War II, mostly ending in the early 1990's. Most of these mortgages were for 10, 15, 20, 25 or 30 years.
Somewhere in the 1980's, lenders studied their books and discovered that the prepayment clauses were actually working against their best interests, contrary to the long held belief that (performing) mortgages were a steady stream of pure profits.
The anomaly comes about because of the so-called "value of a dollar over time" theories.
Example: If I were to have taken out a 30 year mortgage for $100,000 in 1965 at a then prevailing interest rate of say 6%, I'd have locked in the value of 100,000 1965 dollars over a 30 year period. As I pay down my mortgage at say $1000 per month, each month a portion of my payment goes to principal, another portion goes to the escrow account (to pay for insurance on the property and property taxes and in some cases, insurance on the loan itself) with the remainder going to the lender as interest. In the early years of the mortgage, the overwhelming majority of each payment is interest, with only a very small portion going to retire the principal. As the years progress, the portion of each payment going towards interest gets smaller and the amount going towards the principal gets larger. It's not until about the 25th year (or thereabouts) that the majority of each monthly payment is actually going towards principal rather than interest. More importantly as far as the lender is concerned, the money being paid back is actually reduced by the rate of inflation compounded month after month. In other words, a loan that was made in 1965 dollars was being paid off in 1970 dollars, which were worth only a fraction of what a 1965 dollar was worth. In the late 1970's and early 1980's, when the interest rates in the USA briefly touched 20% for the best borrowers, and the (estimated real) rates of inflation were closer to 25%, the lenders realized that their prepayment penalties and prepayment clauses were actually discouraging people from paying off their mortgages early, and that if the mortgages were paid off early, the lenders would at least be getting current dollar values rather than discounted dollar values at some future point in time. So the lenders finally realized that the prepayment clauses worked against their best interests. The best of both worlds, for a lender, would be for the borrower to keep the existing mortgage for a shorter period of time and then refinance, which protects the lenders from the decreasing value of a dollar over time. As far as prevailing interest rates go, they're usually of relatively little consequence to most lenders. Except for now that we are in a historically low period of interest rates. People will lock in these low rates for up to 30 years now, and slowly repay the lenders with discounted dollars, presuming the USA incurs normal inflation as opposed to deflation. See where this line of thought is going??? <g> How will lenders react to stagflation or deflation???
KJC |
