Prepayment Penalty a Surprise

Question: I recently refinanced and was shocked to learn that I had to pay a prepayment penalty. I had never been told about this. How can they spring it on me now?

Answer: Before signing the note, you received a truth in lending disclosure statement that said, “If you pay off your loan early, you may have to pay a penalty.” You signed the statement, acknowledging that you had read it. So how can you tell me now that you had never been told?

Let me answer my own question. You may not have actually read the statement when you signed it.

On the day you were given the statement, you may have had a raft of other documents requiring your signature, so you felt overwhelmed and signed them all. Or perhaps you read the statement but the information about the penalty did not register in your mind.

My answers are based on correspondence I have had with many other borrowers who told me the same thing as you: They didn’t know they had a prepayment penalty until they decided to refinance. The problem seems to be pervasive and suggests that there may be something seriously amiss with the disclosure process. I believe this is indeed the case.

“Prepayment” lies at the bottom of the disclosure statement, the last piece of information on a long form. It reads as follows:

“Prepayment: If you pay off your loan early, you

“[ ] may [ ] will not have to pay a penalty;

“[ ] may [ ] will not be entitled to a refund of part of the finance charge.”

This is a strange set of choices. The negative is definite, “you ... will not have to pay a penalty,” but the affirmative is qualified. The use of “may” denotes a possibility; “may” and “may not” thus mean exactly the same thing. Use of “may” suggests falsely that there may not be a penalty. It would not be surprising if this misleading phraseology put borrowers off their guard.

Because a mortgage loan either has a prepayment penalty clause or it doesn’t, why was the first option not expressed as a “will” rather than a “may”? My guess is that lenders pointed out to the Federal Reserve (which administers truth in lending disclosure statement) that lenders need not enforce the prepayment penalty clause and that when they did not, there would be no penalty.

But this is a hair-splitting point that loses sight of the purpose of disclosure, which is to put borrowers on their guard. Borrowers don’t have to be protected against the possibility that lenders won’t enforce the penalty clause.

In any case, the point about enforcement would be irrelevant if the disclosure was rephrased as follows:

“Prepayment: Your loan

[ ] does [ ] does not have a prepayment penalty clause.”

The second line under “Prepayment” on the existing form indicates whether, in the event of early payment, the lender will refund any of the upfront fees paid by the borrower.

One can almost see the bureaucratic wheels going around on this one, the thinking being that when there is early payment, the borrower might have to pay a fee to the lender, or the lender might have to pay a fee to the borrower, so the disclosure should cover both possibilities.

But lenders never refund fees to borrowers, and even if they did, borrowers need not be warned about the possibility of lender generosity.

This piece of non-information placed immediately below the already weak notice of a prepayment penalty weakens the notice further by diluting the borrower’s attention.

The effectiveness of disclosure declines as the amount of other information with which it is packaged rises. The borrower trying to figure out what the refund option means is not concentrating on the penalty option.

In sum, it is readily understandable why you and many other borrowers signed a disclosure statement but were later surprised to find that you were subject to a prepayment penalty.

The statement does a wretched job of disclosing this critical piece of information.

If the statement did a better job, perhaps we would not see so many states and municipalities enacting laws restricting prepayment penalties altogether.

Don’t expect improvements soon, however. For now, borrowers should understand that a check mark against “may” on the first line under “prepayment” means they have a penalty clause without any doubt whatever, and they should just ignore the second line.

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Jack Guttentag is a syndicated columnist and professor of finance emeritus at the Wharton School of the University of Pennsylvania. Questions or comments can be left at https://www.mtgprofessor.com.

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Distributed by Inman News Features.