A Home Loan Trap

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High Fees Can Prevent Escape From Adjustable Mortgages

Kevin P. Casey for The New York Times

Gertrude Robertson, 91, of Seattle, is selling her home, below. A prepayment penalty will devour most of her equity.

Homeowners whose loan rates are soaring may want to head for the exits. Many of them, though, will find no way out. If they sell their home or refinance, they will face a penalty of thousands of dollars for paying off their loans early.

Tim Larson is in just such a predicament. Two years ago, he refinanced his home outside Minneapolis with a loan at a low interest rate that has since risen sharply. The monthly payment is eating up nearly half of their family income of about $45,000 a year.

T.C. Worley for The New York Times

Tim Larson of St. Francis, Minn., wanted to get a traditional mortgage but could not affird the $9,000 fee to pay off his A.R.M. His 5.6 percent annual mortgage rate has risen to 9.3 percent.

Mr. Larson wants to move into a traditional loan, but can’t see how. He would have to pay the lender a $9,000 exit fee.

“We don’t have any money,“ Mr. Larson said in a phone interview from his three-bedroom house in St. Francis, Minn. “We are barely making our house payments.“

According to the Center for Responsible Lending, these exit fees, called prepayment penalties, were added to more than two-thirds of the adjustable-rate loans. Those loans initially carry a very low interest rate, known as a teaser because it is below the market rate and rises sharply over time.

The lenders say the trade-off is the only way to offer low monthly payments initially because otherwise borrowers would flee when rates adjust upward and make the loan a losing deal. The fees usually equal several months’ interest, and they decline over a few years before disappearing altogether.

Homeowners often think they can keep up with their rising payments or that they will simply refinance later. But the penalties can dash that hope, even if market conditions and their personal circumstances allow it.

Now state governments, regulators and members of Congress are considering whether to rein in prepayment penalties, as consumer advocates suggest. “Borrowers should not be penalized for paying off their debt,” said Ellen Harnick, senior policy counsel to the Center for Responsible Lending, a nonprofit group in Durham, N.C.

Senator Christopher J. Dodd, Democrat of Connecticut, said this week that he would introduce legislation to eliminate the penalties and make other changes in home lending practices.

“About 70 percent of subprime loans have costly prepayment penalties that trap borrowers in high-cost mortgages, mortgages that strip wealth rather than build it, and these penalties keep borrowers from shopping for a better deal,” Senator Dodd said in a hearing of the Senate Banking Committee early this year. When interest rates were high in the 1970s, states took steps to protect consumers from onerous prepayment penalties. Such fees generally disappeared from standard loans. In the late 1990s, though, subprime loans to people with weak credit blossomed, and with those loans came a resurgence in prepayment penalties.

A number of states limit the penalties, but only state-regulated banks are generally subject to those restrictions; mortgage companies and national banks are not.

One state, Wisconsin, actually reversed course and allowed prepayment penalties by state-chartered institutions last year, just as the housing bubble was about to burst. Lenders contended that with lower initial payments, many more people would be able to afford homes and it would level the playing field among lenders.

“You want to give pause before banning prepayment penalties,” said Kurt Pfotenhauer, senior vice president for government affairs at the Mortgage Bankers Association. “They save consumers’ money by lowering their interest rates.”

Mr. Larson and his wife would seem to be good candidates now for a traditional loan. They both have steady jobs: he trims trees, she waits tables. Their fateful refinancing was used to pay off $10,000 in credit card debt accumulated when they traveled to Thailand, his wife’s native country, for their wedding.

The $205,000 loan, which the Larsons signed in February 2005, required them to pay only interest at first, or $11,400 a year, with the 5.6 percent rate to reset after two years. Mr. Larson knew there was a prepayment penalty, but thought it expired in two years; it was actually three years. Now the Larsons’ payments have climbed to $19,000 annually, at a new rate of 9.3 percent.

“It was a loan made with no regard for whether it would be affordable when the rate increased,” said Jordon Ash of Acorn Financial Justice Center, an organization in St. Paul that is trying to help the Larsons. The mortgage broker who advised the Larsons could not be found, and phone calls to the company, Ace Mortgage, were not returned.

Mr. Larson worries that his creditworthiness is sinking as the couple struggle to make the monthly payments. By the time the penalty expires, he may not be able to refinance.

“I had good credit,” he said. “Now it is going down because we can’t keep up. I feel like I am drowning.”

Experts say that many borrowers do not really understand the implications of prepayment penalties — if they are aware they have them at all — and fall prey to sophisticated marketing. In a 2002 lawsuit by Acorn on behalf of a group of borrowers against Household Finance, Acorn said that lenders referred to the practice as “closing the back door” by making it too costly for borrowers to get out of loans with rising rates.

The art of finding borrowers was carefully honed, according to the lawsuit. Among the techniques was sending a check and telling recipients they could have access to a small loan by cashing it. Those who did went on a hot list of prospects in a strategy referred to as target practice, according to the suit.

The penalty “is just an added fee that means more money to the lenders,” said Melissa A. Huelsman, a Seattle lawyer who specializes in predatory lending law. “It is one piece of paper that a borrower signs in a stack of 50 papers. For many people, even if they saw the words, they wouldn’t understand them.”

That was the case for Gertrude Robertson, a 91-year-old widow and nurse’s aide living in Seattle who took out an adjustable-rate mortgage of $450,000 in January.

Even at her age, Mrs. Robertson was earning $3,500 a month, largely by caring for another elderly woman. Then the woman died. Mrs. Robertson’s income was reduced to her monthly Social Security payment of $1,500. Meanwhile, her loan ballooned to $475,000. Unable to make the payments, Mrs. Robertson is listing her home for $510,000.

Mrs. Robertson’s mortgage includes a prepayment penalty of $14,400. A sale at her asking price would not only wipe out any equity but require her to write a check for about $8,600 to cover the penalty and other costs.

Mrs. Robertson says her broker did not give her time to study the loan documents. “Some words I don’t understand,” she said. “When I heard the lady I used to work for tell someone that I was the ‘epitome of cleanliness,’ I went home and cried. I thought I was going to be fired.’ I didn’t know what it meant.”

Last week, Ms. Huelsman persuaded a court in California to waive the prepayment penalty for Mrs. Robertson. She is seeking to have other fees thrown out as well.

The loan was made by New Century Financial, now in bankruptcy protection. The loan servicer, HomeEq, prefers to work one-on-one with customers and does not comment on individual cases, a HomeEq spokeswoman said.

A study by the Center for Responsible Lending shows that borrowers in minority neighborhoods received a disproportionate share of loans with prepayment penalties. The Pew Hispanic Center reported in 2002 that African-American families had a median net worth of just under $6,000. Hispanic families had nearly $8,000. For white Americans, the median net worth was $88,651.

Waiting out the expiration of a penalty, especially a short one, does not sound so bad — until home prices turn south.

That is what happened to Dorinda Weisman, a social worker in Elk Grove, Calif. In 2005 she borrowed $353,000 from Pacific American Mortgage to buy a home in Sacramento with a small down payment. The prepayment penalty, of $9,000, expired in just a year.

“One of the things I always wanted was to own a house,” Ms. Weisman said in a telephone interview. “I was a single parent, and my son is a hemophiliac. I had been living in a middle-class African-American neighborhood that went downhill after the drugs came in.”

By the time the penalty expired, her house had declined in value. Refinancing was no longer possible.

Her interest rate had shot up to 9.8 percent from 4.75 percent. She says about 85 percent of what she brings home — her salary is $60,000 as a social service consultant with the state government — now goes to the mortgage.

She is trying to negotiate a new loan with the help of the Neighborhood Assistance Corporation of America, a nonprofit home ownership organization based in Jamaica Plain, Mass.

“Like a lot of people, the adjustable ate up her equity,“ said her mortgage broker, Antonio Cook of Toneco Financial. “She’s got to ride it out and sacrifice. I tell people, ‘I don’t care if you eat bologna sandwiches, just pay your bills on time.’ If she can ride it out, things start coming up good.”

Copyright 2007 The New York Times Company. Reprinted from The New York Times, Business Day, of Thursday, September 13, 2007.