KEVIN CUFF
‘Market acceptance’
Borrowers in minority neighborhoods face greater odds of receiving a subprime prepayment penalty by a statistically significant margin, according to the Center for Responsible Lending in North Carolina. In a second report, CRL finds that penalties convey no interest-rate benefit for borrowers. And now local mortgage associations are weighing in on the latest findings.
Mortgage lenders – especially in the subprime market – sometimes require that borrowers retain their loan for a certain period of time or pay a penalty when the loan is paid off or refinanced. The prepayment penalties are designed to protect the lender’s profit margin and salability of the loan on the secondary market.
“The evidence is now clear. Prepayment penalties in subprime loans are locking African-American families out of the prime mortgage market and rolling back hard-earned economic progress,” said Hilary Shelton, director of the National Association for the Advancement of Colored People bureau in Washington, D.C. “[The] report provides more empirical evidence that African-Americans are second-class citizens in the subprime market and that skin color determines the terms of credit that a family receives. Clearly, there is a dire need for reform to curtail these discriminatory and injurious practices.”
CRL is a national, nonprofit, nonpartisan research and policy organization dedicated to protecting homeownership and family wealth by working to eliminate abusive financial practices.
In the first study, “Borrowers in Higher Minority Areas More Likely to Receive Prepayment Penalties on Subprime Loans,” CRL examined the incidence of prepayment penalties in ZIP code areas with defined concentrations of minority residents using a complex statistical approach involving “multivariate regression models.” The study was based on a nationwide sample of 1.8 million loans originated from January 2000 to July 2004.
“This analysis shows that borrowers in minority neighborhoods receive a disproportionate number of loans with prepayment penalties,” the report said.
For borrowers living in ZIP code areas where more than half of the residents represent minority groups, the odds of receiving prepayment penalties are 35 percent higher than those of similarly situated borrowers in ZIP codes where minorities comprise less than 10 percent of residents.
The report also looked at general trends in the subprime mortgage market as a whole. Seventy percent of such loans carried a prepayment penalty. More than 65 percent of the sample loans had a prepayment penalty term of at least two years and one in 10 loans included a prepayment penalty with a term of five years or longer.
In a second study, “Borrowers Gain No Interest Rate Benefits From Prepayment Penalties on Subprime Mortgages,” CRL investigated whether prepayment penalties convey benefits to borrowers commensurate with their costs.
“The evidence presented here shows that, in fact, borrowers with subprime loans fail to receive lower interest rates and, in some cases, actually pay a higher rate than similarly situated borrowers with subprime loans without prepayment penalties,” the report said.
For its study, CRL examined loan-level data from approximately 500,000 subprime loans. Researchers analyzed fixed-rate, 30-year loans originated during a three-year period.
The research found that “borrowers with prepayment penalties paid similar interest rates to similarly situated borrowers who did not have penalties” in refinance loans. For home purchase loans, borrowers who had subprime loans with prepayment penalties paid higher interest rates than similarly situated borrowers who had subprime loans without prepayment penalties.
“These findings are shocking,” said Mark Pearce, CRL president. “Not only do prepayment penalties lock borrowers into a higher-cost subprime market or force them to give up the wealth they have built through homeownership, but they also turn out to offer no benefit to borrowers in the form of lower interest rates, as the subprime industry has claimed. These abusive prepayment penalties operate as a hidden fee that disproportionately affects both rural and minority neighborhoods.”
Offsetting Risk
The spokesman for one local mortgage trade group, however, said that the study may not be entirely accurate and, even if it is, does not reflect activity in the local lending market.
Kevin Cuff, executive director of the Massachusetts Mortgage Bankers Association, calls the reports confusing and complicated.
“We are hopeful that a targeted survey of 400,000 loans [per] year in ZIP codes with defined concentrations of minority residents is an accurate and appropriate method of measuring their conclusions,” Cuff said. “We have read the report and although we are not mathematicians skilled at regression analysis, we do believe it somewhat inconsistent to say that their regression analysis demonstrates the disadvantage of a prepayment penalty program.”
Cuff also explaind the need for prepayment penalties.
“There are fundamental reasons why prepayment penalties are used based upon levels of risk and the time protections for the ultimate investor,” Cuff explained. “From our membership, most loans are all quoted accurately with the prepayment penalty present in the loan. This is very consistent with lenders in order to secure investors’ commitments. In Massachusetts, many loans have an option of the prepayment penalty vs. a higher rate or points. This is disclosed appropriately and left to the consumer [to decide which option is best].”
James Dougherty, executive director of the Massachusetts Mortgage Association, said when lenders take advantage of consumers with an equity-stripping loan, such behavior results in a black eye for the mortgage industry.
“It is bad for all of us,” Dougherty said.
But do reports like CRL’s findings negatively impact the mortgage industry? Dougherty said no.
“The [subprime] market has been anything but curtailed [by negative reports],” he said.
Cuff also said subprime lending activity has not been hurt by reports detailing abuses.
“We have already learned that the [subprime mortgage] market has increased dramatically. There is a tremendous demand for those loans not traditionally purchased by FNMA [Federal National Mortgage Association, commonly known as Fannie Mae] and FHLMC [Federal Home Loan Mortgage Corp., or Freddie Mac]. The lending community is going to have to develop some consistent balance of risk for these increasing gaps from the traditional Fannie and Freddie market,” Cuff said. “Incidentally, Fannie and Freddie both have prepayment penalties of up to three years – hence there is a built-in secondary market acceptance for the need to offset certain risk.”
Restrictions, like ones from Fannie Mae and Freddie Mac, in which secondary market buyers will not invest in subprime loans with penalties in effect beyond three years, have had no discernible effect on the availability of subprime loans or the “rapid growth” of the subprime market, according to the CRL study.
According to CRL, in 2000, the U.S. subprime mortgage market was $138 billion. Three years later the market was $332 billion.
CRL said laws banning prepayment penalties are effective in at least nine states, including states that allow for limited exceptions. Other states have imposed specific limits, including limits on the amount of fees associated with the penalties, permissible loan types or additional lender disclosure requirements.
Massachusetts recently amended its law regarding prepayment penalties, which stipulates when a penalty is allowed and the acceptable amount. It states that if a loan is paid before the date fixed for payment, a borrower will pay the balance of the first year’s interest or three months’ interest, whichever is less. The law also notes exceptions to that rule.
Cuff said while studies sometimes cast lenders in a negative light and he is unsure about the accuracy of the CRL results, such reports can be helpful to industry practitioners. However, more localized studies that focus on the communities that Massachusetts lenders work in tend to offer more guidance to MMBA members. Cuff said national studies like CRL’s tend to offer less information because Massachusetts may not have a similar market as another area of the country.
Jennifer Jope may be reached at jjope@thewarrengroup.com.
