Pre-Payment Penalties (PPP) are often used as a tool by mortgage broker/bankers to increase the amount of YSP a Lender will allow them to charge. The theory behind this is that Lenders don’t mind paying larger amounts of YSP if they can guarantee a recoup of some of the cost via a PPP, should the loan be paid off/refinanced ‘early’.
For example, a loan without a PPP may only allow a broker/banker to charge up to say, 1% in YSP. By adding a PPP the Lender will up the broker YSP ceiling allowance to say, 2.5%.
There are a few variables to PPP’s as well. Term..1 year, 2 year, 3 year…and Type..Hard or Soft.
A 1 year hard prepay at 1% indicates that if the loan is paid off/refinanced at anytime within 12 months, the Lender may/will charge (typically) 1% of the original loan amount. After the 12th month the PPP goes away. The PPP amount is the same if the loan is paid off in month 1 or month 12.
A 3 year soft PPP at 2% indicates that if the loan is paid off/refinanced at anytime within 36 months, the Lender may/will charge a prorated amount depending on the age of the loan. For example:
The original loan amount is $100K
The 3-Yr soft PPP is 2%, which equals $2000.
$2000 divided by 36 (months) = $55.55/month.
As each month passes, the (soft) PPP dollar amount decreases by $55.55.
Loan is paid off/refinanced in month 12, leaving 24 months worth of PPP left, or $55.55 x 24 = $1333.33.
If this was a Hard PPP, the dollar amount would remain $2000, regardless if the loan was paid off in month 2 or month 35.
PPP’s, hard or soft, are designed to afford a consumer a lower interest rate in exchange for the ‘extened commitment/early payoff insurance policy’. Unfortunately, many bankers/brokers use them to increase their commissions, while locking a consumer into a more expensive loan.