Study Finds No Bias in Prepayment Penalties

A study for the National Home Equity Mortgage Association states that the interest rate a borrower pays on his or her mortgage loan is directly related to his or her credit risk profile.

A second study said putting a prepayment penalty in the loan agreement resulted in a lower rate for the borrowers.

NHEMA requested the law firm of Sirote & Permutt PC, Birmingham, Ala., to commission the studies, which were done by Richard F. DeMong and James E. Burroughs of the University of Virginia's McIntyre School of Commerce. The pair looked at over 961,000 mortgage loans originated nationwide during 2004 by lenders that specialize in nonprime lending.

"The question of how certain risk factors and the presence of prepayment fee clauses affect mortgage pricing came up when I testified at House of Representatives Financial Services Committee hearings last year," said Mr. DeMong in a statement issued by NHEMA.

"I had to admit I didn't know of any hard data on these issues that could help the committee members. That's when I started moving forward on these studies. They directly address the vital questions - is the mortgage market efficiently pricing loans based on risk? Are prepayment fee clauses on loans an option that really benefit consumers? Those questions go to the heart of informed consumer choice and effective policymaking."

In doing the study, the pair said they expected that if there was a prepayment fee, the higher the borrower's credit score, and the higher the borrower's monthly income, the annual percentage rate of the loan should be lower, all else being equal.

"This was the case. The higher the FICO score, the lower the APR, all other factors held constant. The other factors that were inversely related were monthly income, the presence of a prepayment fee and owner occupancy, as expected. The APR of the first-lien mortgage would be lower if borrower's income was higher, if the loan had a prepayment fee, or if the home was occupied by the owner," the report on pricing said.

Besides having a lower APR, these borrowers were able to borrow a greater amount and have a higher loan-to-value ratio, the study concluded.

As for prepayment fees, that report said approximately three-quarters of the loans they looked at had a prepayment fee.

"Contrary to what some have said, prepayment fees were no more likely for borrowers with low FICO scores than high ones. In fact, for fixed-rate mortgages, the trend is clearly upward, with higher-FICO-score-borrowers more likely to opt for mortgages with prepayment fees.

"This is substantive because it points toward prepayment fees being used by borrowers (particularly high-FICO borrowers, who presumably have more options) to reduce the rate of the loan, as opposed to some mechanism used by lenders to extract additional fees from those with limited options, as has been contended by some," the report on prepayment fees said.

On average, a loan with a prepayment penalty has an APR, which is 38 basis points lower than one that does not have one, the pair said.

Ironically, there is no constant on whether the reduction is larger as the credit score gets higher, except for borrowers whose credit score is greater than 720.

Those borrowers saw an average reduction in APR of 57 basis points.

Borrowers with scores of between 691 and 720 had a 43 bp reduction, with borrowers with scores of between 511 and 540 and 661 and 690 each getting a 41 BP reduction. The next largest reduction, 39 bp on average, was for the worst category of applicants, those with scores under 510.

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