The Impact of Predatory Loan Terms on Subprime Foreclosures: The Special Case of Prepayment Penalties and Balloon Payments

The authors acknowledge financial support from the Center for Responsible Lending (CRL). However, the views expressed here are those of the authors and do not necessarily represent the views of CRL. The authors would also like to thank Karen Pence for providing us with her database on state foreclosure laws. 1 ABSTRACT There are growing concerns about the way predatory mortgages erode housing equity. In this paper, we examine a potential additional impact: the relationship between abusive loan terms and foreclosure. Do predatory characteristics increase the likelihood of foreclosure once other risk factors are taken into account? We examine this question by estimating the impact of two loans characteristics—prepayment penalties and balloon-payment requirements—on foreclosure using a national database of subprime refinance first-lien loans originated in 1999. We find that these predatory loan features lead to a significant increase in mortgage foreclosure risk, even after controlling for other risk factors. For instance, refinance loans with prepayment penalties and those with balloon payments are more likely to experience a foreclosure than loans without these characteristics—by about 20 percent and 50 percent, respectively. These findings suggest that predatory loans have the potential not only to erode household wealth but also to heighten the negative impacts on individuals, households, and communities associated with foreclosure. Furthermore, we estimate that the use of prepayment penalties and balloon payment requirements in 1999 refinance originations increased foreclosure-related losses by about $465 and $127 million nationally, respectively.