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Loans with prepayment penalties or balloon payments
Studies have shown that people who refinance their homes with loans containing balloon payments or prepayment penalties are more likely to end up in foreclosure.
Prepayment penalties and balloon payments are often found in mortgages carried by people with poor credit. These "subprime" mortgages have higher rates, and thus, higher foreclosure rates than conventional mortgages.
It is estimated that a loan with a prepayment penalty increases the likelihood of foreclosure by a staggering 20 percent. Mortgages with balloon payments are 46 percent more likely to go into foreclosure than loans without balloon payment provisions.
The problem with prepayment penalties is that they punish borrowers for refinancing, whereas a balloon payment punishes borrowers if they don't refinance (borrowers must pay the loan in full in a lump-sum in a given period of time). Both are very poor provisions to have in loans. In the case of prepayment penalties, you can be punished not only for refinancing a home, but also for selling it!
So just what is a common prepayment penalty? The "usual' penalty is a fee of six months' interest on the outstanding balance of the loan. For someone who borrowed $200,000 at 12 percent (remember we're talking about less than stellar credit scores) interest, and who then sold the home a year later, would have to pay a penalty of about $12,000 for paying the loan off early. Ouch. The penalty has the effect of keeping the borrower in their bad mortgage, one they likely cannot afford, until they become increasingly delinquent, and eventually enter foreclosure.
These types of loans, although perfectly legal, prey on unsuspecting naïve people. As bad as they are - they are costly, applied unfairly, result in a higher than normal foreclosure rate - they don't even give the borrower a break in the interest rate. People get hooked into these loans because the lender will often offer lower mortgage fees.
If you have less than excellent credit, you would be much better served by getting your credit situation in order than in taking on one of these bad loans.
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