Penalty Restrictions Will Apply to High-Cost Mortgages

Prepayment penalties, once the rage of mortgage originators, will soon face near demise, according to Jonathan Foxx, president and managing director of Long Beach, N.Y.-based Lenders Compliance Group, a risk management firm specializing in mortgage and lending regulatory compliance.

"Used ostensibly to offer better terms to the borrower, and not coincidentally also providing increased income to the originator, these penalties tended to lock borrowers into their loans when they wanted to refinance, making it financially infeasible for many borrowers to refinance without loss of equity. Yet there was rarely any discipline, let alone motivation, on the part of the originators to implement policies to curtail the use of prepayment penalties," Mr. Foxx recently wrote in his company blog. "The government, belatedly but finally, has said, 'Enough!'"

His opinion is that new restrictions will reduce the incentive to use prepayment penalties in residential mortgage loans. On Oct. 1, 2009, the new and final revisions to Regulation Z, the implementing regulation of the Truth in Lending Act, will take effect.

"It has taken some time (and a mortgage meltdown) for these needed changes to become the law of the land. Especially in the current economic environment, when millions of borrowers are seeking to refinance their mortgages, the debilitating aspects of prepayment penalties needed to be reduced, if not eviscerated."

Prepayment penalty restrictions will soon apply to not only "high-cost" but also "higher-priced" mortgages. The higher-priced mortgage loan, a new category created under Regulation Z, tests for rate, but not fees.

If the annual percentage rate exceeds a new index, called the "average prime offer rate" by a specific amount, the loan is considered "higher priced."

According to Mr. Foxx, this index is not the same one used to calculate the high-cost loans.

Instead, this is a new index, based on Freddie Mac's Weekly Primary Mortgage Market Survey and will be published by the Federal Reserve Board.

"Clearly, the revisions to Regulation Z contemplate reining in the kind of loan origination initiatives that utilize prepayment penalties, especially in loan products that require periodic increases to the mortgage payment," Mr. Foxx writes.

"The effect of having the prepayment penalty restrictions apply to both the high-cost and higher-priced loan categories will be that all subprime and most alt-A loan products will be affected."

He says creditors will only be able to impose a prepayment penalty for the first two years after consummation, thus jettisoning the previous five-year period imposition, and the lender's pricing incentive in relation to the per-loan revenue will be significantly lowered.

"The lender must qualify the borrower's DTI before consummation by utilizing all appropriate verifications of income and documenting them. Therefore, the borrower's ability to repay must be verified prior to relying on it to impose prepayment penalties."

Currently Regulation Z prohibits a "pattern or practice" of lending without regard to the borrower's ability to repay, he describes, which provides a presumption of a violation only if a pattern or practice can be established where income verification is not processed or documented adequately.

"This language has been removed in the final rule, further exposing lenders to heightened diligence in reviewing a borrower's ability to repay. Consequently, it will soon be a violation of TILA for any high-cost or higher-priced loan to be originated without regard to a borrower's ability to repay from income and the collateralized assets."

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