Prepayment penalty, balloon and variable rate mortgages

Article by R. Joseph Ritter, Jr. CFP® EA

“I have the option of taking out a balloon mortgage or variable rate mortgage. Is this a good decision?”

The attractiveness of mortgages with fanciful provisions such as prepayment penalties, balloon features and variable interest rates is the initial affordability of the monthly payment. Features such as these can make your dream home more affordable. The reason the initial payment is more affordable is because in future months there is significant potential for your loan to cost you quite a bit more than you may have expected and create a higher potential for profit to the lender.

Before we go further, let’s define some of these terms:

  • Prepayment penalty is a fee charged by the lender if you completely pay off the mortgage within a certain term, usually 2 to 3 years.  This is expressed as a percentage of the loan amount and can be as much as 6% or more. For example, a loan of $150,000 would have a prepayment penalty of $9,000. The penalty amount will vary from lender to lender.
  • Balloon means that the entire amount of the mortgage is due within a certain term such as 3 or 5 years. Balloon mortgages often have fixed interest rates, however, you are required to pay off or refinance the mortgage at the end of the balloon term.
  • Variable interest rate mortgages often begin with a short period of fixed interest rates such as 2 or 3 years. After that time, the interest rate may be adjusted according to the terms in the loan. Lenders will use a published interest rate such as the LIBOR and add several percentage points to that rate to determine what your new rate will be.  Most loans cap the amount of each adjustment by a certain percentage, such as 1% or 1.5%. For example, if your loan is 6% plus the LIBOR rate and the LIBOR rate is 7%, your new interest rate will be 13%. However, if your initial interest rate is 5.25% and the loan terms provide for maximum adjustments of 1.5% every 6-12 months, then the first adjustment will be 5.25% plus 1.5%, or 6.75%. This does not mean your interest rate will not reach 13%.  It will eventually.

The major issue with a prepayment penalty is that no one can predict the future. You may get a mortgage with a prepayment penalty because the initial cost of the loan or the interest rate is a little cheaper, but there is no guarantee you will keep the loan until the penalty term expires. Loss of a job, changes in health, and many other factors can occur unexpectedly, forcing a move, house sale and triggering the penalty. Plus, you are locked into your mortgage even if interest rates later decline. The prepayment penalty should be avoided whenever possible.

The downside of a balloon mortgage is that you are forced to refinance the mortgage by a certain time regardless of the interest rates at that time and regardless of your income, credit and employment status. As with the prepayment penalty, no one can predict the future. If you are unable to refinance the mortgage at the end of the balloon term, you can be facing an automatic imposition of unfavorable loan terms. Again, you may get the loan at a lesser cost, but it boxes you into a position you may not be able to fulfill in 3 to 5 years.

Variable interest rate mortgages are often cheaper than fixed rate mortgages, and for good reason. The lender stands to make a substantial profit off the higher interest rate once it starts to adjust up. It is essentially gambling that in a few years interest rates will be low enough that the adjustment will not substantially affect your monthly payment.  What you may not realize, however, is that the interest rate index your loan uses as a benchmark is probably already close to the interest rate on a standard fixed rate mortgage, so your interest rate is almost guaranteed to adjust up significantly.

If you or I could accurately predict the future, these loan features may be worth having. Unfortunately, we are unable to predict the future, and even in the best case scenario obtaining a mortgage with any of these features is likely to cause you trouble at some point.

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