Disclosure Rules on Mortgage Prepayment Penalties
September 10, 2001, Revised April 13, 2002, September 21, 2002, November
4, 2002, November 27, 2006, January 9, 2008
Many borrowers are surprised to find that they are subject to a prepayment penalty because the Truth In Lending disclosure is very poor. Borrowers should understand that if the TIL says that they "may" be subject to a penalty, it means that they will be subject to a penalty.
"I recently I went to refinance 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?"
Before signing the note, you received a Truth in Lending Disclosure Statement (TIL) 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 TIL, you may have had a raft of other documents requiring your signature, so you felt overwhelmed and signed them all. Or, you may actually have read the TIL but the information about the prepayment penalty did not register in your mind.
My answers are based on correspondence I have had with many other borrowers who told me essentially the same thing as you: they didn’t know they had a prepayment penalty until they went 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 TIL, 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 dictionary says that "may" refers to "a possibility"; "may" and "may not" thus mean exactly the same thing. Use of the word "may" suggests falsely that there may not be a penalty. It would not be surprising if this misleading phraseology put borrowers off their guard.
Since 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 TIL) that lenders need not enforce the prepayment penalty clause, and in cases where they didn’t 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:
[ ] does [ ] does not have a prepayment penalty clause
The second line under "Prepayment" on the existing TIL form indicates whether or not, in the event of early payment, the lender will refund "part of the finance charge." There is no good reason for this being here. Lenders never refund fees to borrowers, and even if they did, borrowers need not be warned about the possibility of lender generosity.
What this item does is cause confusion. "Finance charge" on the TIL consists of upfront fees plus cumulative interest payments over the entire term of the loan. The TIL describes it as "The dollar amount the credit will cost you." When borrowers see that they will not "be entitled to a refund of part of the finance charge", they wonder if that means that they must pay all the interest through term when they prepay the loan? I have had this question asked of me by dozens of borrowers.
The answer is "no". Interest payments cease when the loan balance is paid off. The statement is meant to alert borrowers to the fact they will not get a refund of any fees paid upfront.
Because this confusing and wholly unnecessary statement is placed immediately below the already weak notice of a prepayment penalty, it weakens the penalty 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 TIL but were later surprised to find that you were subject to a prepayment penalty. The TIL does a wretched job of disclosing this critical piece of information. If they did it better, perhaps we would not see so many states and municipalities enacting laws restricting prepayment penalties altogether.
Don’t expect improvements in the TIL anytime soon. Meanwhile, borrowers receiving a TIL for the first time 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.
Many borrowers are surprised to find that they are subject to a prepayment penalty because the Truth In Lending disclosure is very poor. Borrowers should understand that if the TIL says that they "may" be subject to a penalty, it means that they will be subject to a penalty.
Why Borrowers Are Often Surprised to Find That They Must Pay a Prepayment Penalty
"I recently I went to refinance 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?"
Before signing the note, you received a Truth in Lending Disclosure Statement (TIL) 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 TIL, you may have had a raft of other documents requiring your signature, so you felt overwhelmed and signed them all. Or, you may actually have read the TIL but the information about the prepayment penalty did not register in your mind.
My answers are based on correspondence I have had with many other borrowers who told me essentially the same thing as you: they didn’t know they had a prepayment penalty until they went 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.
The TIL Disclosure of Prepayment Penalties Is Horrendous
"Prepayment" lies at the bottom of the TIL, 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 dictionary says that "may" refers to "a possibility"; "may" and "may not" thus mean exactly the same thing. Use of the word "may" suggests falsely that there may not be a penalty. It would not be surprising if this misleading phraseology put borrowers off their guard.
Since 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 TIL) that lenders need not enforce the prepayment penalty clause, and in cases where they didn’t 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
Compounding the Problem With a Garbage Disclosure
The second line under "Prepayment" on the existing TIL form indicates whether or not, in the event of early payment, the lender will refund "part of the finance charge." There is no good reason for this being here. Lenders never refund fees to borrowers, and even if they did, borrowers need not be warned about the possibility of lender generosity.
What this item does is cause confusion. "Finance charge" on the TIL consists of upfront fees plus cumulative interest payments over the entire term of the loan. The TIL describes it as "The dollar amount the credit will cost you." When borrowers see that they will not "be entitled to a refund of part of the finance charge", they wonder if that means that they must pay all the interest through term when they prepay the loan? I have had this question asked of me by dozens of borrowers.
The answer is "no". Interest payments cease when the loan balance is paid off. The statement is meant to alert borrowers to the fact they will not get a refund of any fees paid upfront.
Because this confusing and wholly unnecessary statement is placed immediately below the already weak notice of a prepayment penalty, it weakens the penalty 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 TIL but were later surprised to find that you were subject to a prepayment penalty. The TIL does a wretched job of disclosing this critical piece of information. If they did it better, perhaps we would not see so many states and municipalities enacting laws restricting prepayment penalties altogether.
Don’t expect improvements in the TIL anytime soon. Meanwhile, borrowers receiving a TIL for the first time 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.