What is the advantage of a prepayment penalty mortgage from the perspective of the lender?

Question

What will be an ideal response?

Answer 1

The advantage of a prepayment penalty mortgage from the perspective of the lender is that the lender can reduce losses if the borrower chooses to pay off the mortgage when rates fall. More details are given below.

Effectively, the borrower's right to prepay a loan in whole or in part without a penalty is acalled an option. A mortgage design that mitigates the borrower's right to prepay is theprepayment penalty mortgage. This mortgage design imposes penalties if borrowers prepay.The penalties are designed to discourage refinancing activity and require a fee to bepaid if the loan is prepaid within a certain amount of time after funding. Penalties are typicallystructured to allow borrowers to partially prepay up to 20% of their loan each yearthe penalty is in effect and charge the borrower six months of interest for prepayments onthe remaining 80% of their balance. Some penalties are waived if the home is sold and aredescribed as "soft" penalties; hard penalties require the penalty to be paid even if the prepaymentoccurs as the sale of the underlying property.

The laws and regulations governing the imposition of prepayment penalties are established at the federal andstate levels. Usually, the applicable laws for fixed-rate mortgages are specified at the state level. There are statesthat do not permit prepayment penalties on fixed-rate mortgages with a first lien. There are states that do permitprepayment penalties but restrict the type of penalty. For some mortgage designs, such as adjustable-rate andballoon mortgages, there are federal laws that override state laws.