Why Banks Hate Pre-Payments

Why Banks Hate Pre-Payments

One thing I did not understand completely was why banks and lending institutions charge borrowers large fees for pre-paying mortgages or increasing payments as they see fit. This is something I did not understand completely until I came across this recently.

The industry has actually termed this prepayment risk. In this context: Pre-Paid refers to making payments against loans that exceed those as set out in your loan agreement. As an individual that was considering risk, I always thought that this was in the best interest of both parties. The lender gets their money faster and they do not have to worry about securing their payments. The borrower is satisfied because they have paid off the loan early and do not have to deal with that debt.

Prepayment risk is defined as the early return of principal on a fixed income investment. 

The problem is lenders are in the business of taking on risk and prepayments result in two problems

1.  They need to find another person to loan money to

2. They need to find another investment vehicle that earns the lender the same return on investment

That second point really hammered home the topic. Recently, I started peer-peer lending and I came across a wonderful opportunity. Two months in, the borrower paid his loan back in full and I was left with my capital and a measly two months of interest payments. The problems as investors is not necessarily finding places to deploy new capital as those opportunities are plentiful; but moreover, finding the opportunities that pay a good return and satisfy your risk appetite. The problem that lenders face is not the return of capital when someone pre-pays but actually losing out on the future interest payments that were due to come to them.

 So what do you do as a consumer?

Frankly as a consumer you should not care about the lender. As a borrower, you want to make your interest costs as low as possible ensuring that a greater proportion of your payment goes to paying down your principal or finding ways to reduce your amortization period. The amortization period (amt) is the number of periods (usually years) it will take you to pay down your loan.

In many cases when interest rates decrease, it is advantageous to pay down your mortgage or loan aggressively. Since a mortgage payment is comprised of payment against your loan and the interest, with lower rates your interest component is smaller, allowing you to pay down your loan amount quicker leading to greater equity buildup. This equity buildup is your “so-called stake in the property” and is yours to keep when you ultimately sell the property.

Tips

  • Ensure that when you sign on the dotted line there are no prepayment fees.
  • Keep an eye on interest rates to see when it is most beneficial to increase your payments

 

Disclaimer: All of the above information is my own personal opinion. Examples are for learning purposes only. Please speak with a licensed loan representative when making any financial commitments. 

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Tips from the newly minted worker

Tips from the newly minted worker

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Are markets efficient?