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Santa, please do away with prepayment fees

‘We bailed out the banks, so why don’t the banks bail out consumers?”

For the past two years, the most difficult question to answer has been the one raised by homeowners who have toed the line. They have made their payments on time, regardless of declining values. They have seen other owners who are behind on their loans qualify for a loan modification, then default again. Still, those “who have done the right thing” have been offered no relief.

Many borrowers who would like to refinance at today’s lower interest rates face significant prepayment penalties for doing so. The typical prepayment penalty is six months’ interest on 80 percent of the loan balance. Lenders put the blame on secondary market investors who refuse to budge on terms.

It seems that leaders are eager to help owners who are underwater (owe more than the value of their homes). That’s because the bank does not want to take the home back – and the costs associated with it. However, lenders are doing nothing for borrowers with considerable equity in their homes. Lenders know if they foreclose, there’s plenty of cash to satisfy any debt.

One reader said the experience has been like trying to secure financial aid for his college-bound daughter: “There’s plenty of money for low-income people, and the rich don’t need it. But people in the middle don’t qualify for anything.”

He’s right. Some people can’t afford to refinance their homes even if they wanted to. Helping people with good credit and excellent payment histories to refinance their homes would pay dividends in the long term. That’s because refinancing to a lower interest rate would lower their monthly payments and reduce the possibility of default and foreclosure.

There has never been a time where more borrowers have owed more money on their homes. Nearly one in four owners now owes more than the home is worth. It’s time to place a moratorium on prepayment penalties, and here’s why:

Many of the owners who would like to refinance now have adjustable-rate mortgages. These adjustables, approximately $321 billion strong and scheduled to reset before 2012, could well drive the number of bank-owned homes to an untenable number if owners default. If those properties become vacant, they would create a drag on neighborhoods that would further lessen the desire of many other homeowners to hang on.

In a report titled “Option ARM-ageddon: The Real Reset Risk,” Barclays Capital’s researchers predicted that monthly payments on a majority of the existing loans to be adjusted would jump by 60-80 percent. By comparison, most of the much publicized subprime adjustments caused only an 8 to 10 percent increased payment shock.

The study included several subprime/Option Arm comparisons, including a $250,000 loan on similar homes in the same neighborhood. While the mortgages carried different interest rates, margins and loan caps, the mortgages were typical for what a borrower could expect.

The subprime loan made in 2006 was recast after two years under its original terms and the monthly payment rose from $1,903 to $2,044, or 7.4 percent. The Option ARM, recast when the borrower hit the loan’s ceiling, saw its monthly payments leap 89 percent, from $1,074 to $2,027.

Recasting (or recalculating a loan) is another way of limiting negative amortization and keeping a loan on the original schedule. The main purpose of recasting is to ensure that the loan is paid off within the scheduled amortization period.

Option ARM loans are usually recast every five or 10 years. This recalculation (or re-amortization) is based on the outstanding principal balance, the remaining term and the fully indexed rate. When the loan is recast, the payment required to fully amortize the loan over the remaining term becomes the new minimum payment.

We cannot afford more foreclosures – especially when there are logical steps we can take to prevent them. Mortgage interest rates are at record lows, yet many people can’t get them because of a prepayment penalty on their existing loan.

Does that seem right? After all we have done to keep banks in business?

Tom Kelly is a former real estate editor for the Seattle Times. His book “Cashing In on a Second Home in Mexico: How to Buy, Rent and Profit from Property South of the Border” was written with Mitch Creekmore of Stewart International.