As part of revised mortgage lending guidelines released on July 14, 2008, the Federal Reserve Board has substantially reduced barriers to refinancing mortgages, especially on those loans where the borrower may have the most to gain by refinancing.

In the current mortgage crisis, prepayment penalties have restricted some of the mortgage refinancing and restructuring that might otherwise have helped borrowers get out of loans that have become burdensome. Subprime and adjustable rate mortgages have been the most common examples of such loans.

A prepayment penalty is a charge for any form of early repayment of the mortgage, either by refinancing or simply by paying off the principal in advance (though most programs allow you to prepay up to 20% of the principal per year without penalty). In the context of subprime loans, prepayment penalties can create a financial obstacle to a refinance that otherwise would save the borrower in the long run.

New Loan Category

In connection with the new guidelines, the Fed has created a new loan category it has dubbed "higher-priced mortgage loans." This will clear up some of the confusion that sometimes surrounded the use of the term "subprime loans." The Fed's new category will encompass loans made to borrowers with lower credit ratings, but will also include mortgages issued at an interest rate premium for other reasons.

The new category defines a "higher-priced mortgage loan" as a mortgage issued at 1.5% or more above the average prime mortgage rate for primary mortgages, or 3.5% above the average prime mortgage rate for subordinate lien mortgages, such as second mortgages.

New Refinance Rules

The Fed's new rules cover a variety of lending practices related to these higher-priced mortgages and to adjustable rate loans, but for refinancing the most important provisions are these

• The Fed will allow no prepayment penalties on mortgages with payments that vary within the first four years of the loan. This will give people who experience "sticker shock" due to adjustable rates or other payment variations the opportunity to rework their loans.
• The Fed will not allow any prepayment penalty to last more than two years for higher-priced loans, substantially reducing the amount of time borrowers can be locked into a mortgage. Subprime borrowers who have cleaned up their credit will be able to refinance to prime mortgages sooner.
• Lenders will not be allowed to describe loans as "fixed" when in fact the rate can change. In addition, refinancing borrowers will be provided with more disclosure than in the past. Currently, estimates of loan costs are only required for home purchase loans.

Those refinancing in the future will not only have more flexibility, they will also be provided more disclosure and better information. These new regulations will apply to mortgages originated from October 1, 2009 onward.

Importance of Refinance Flexibility

Restricting prepayment penalties will substantially increase the refinance flexibility of borrowers. Given that mortgages are most commonly written for terms of thirty years, refinance flexibility is an important risk management tool for borrowers.

While refinancing is most commonly associated with situations where mortgage rates have fallen, it has other important applications. For example, even if market rates have stayed roughly the same, a borrower whose credit rating has substantially improved should be able to get a lower interest rate by refinancing. Refinancing can also be used to lower payments by spreading the principal balance out over a longer period of time, or to stabilize payments by switching from an adjustable-rate to a fixed-rate mortgage.

Source:

U.S. Federal Reserve Board

About the Author: