Predatory loan terms, namely prepayment penalties and balloon payments, increase the risk of mortgage foreclosure in subprime home loans, even after controlling for the borrower’s credit score, loan terms and varying economic conditions, according to a report by the Center for Community Capitalism at The University of North Carolina at Chapel Hill.

While previous studies have demonstrated a correlation between subprime lending and foreclosures, these findings show that specific abusive loan terms lead to additional home losses.

“The study demonstrates that subprime prepayment penalties and balloon payments place Americans at substantially greater risk of losing their homes,” said Dr. Michael A. Stegman, director of UNC’s Center for Community Capitalism, part of the Frank Hawkins Kenan Institute of Private Enterprise. “Given the significant financial and emotional costs associated with foreclosure on families and neighborhoods, policymakers should take note.”

Foreclosure has become central to public policy debates, as the subprime market has expanded. Subprime loan originations grew more than nine-fold, from $35 billion to $332 billion between 1994 and 2003. In the fourth quarter of 2003, 2.13 percent of all subprime loans across the country entered foreclosure, which was more than 10 times higher than the rate for all prime loans.

Over time these foreclosure start to accumulate. For example, 20.7 percent of all first-lien subprime refinance loans originated in 1999 had entered foreclosure by December 2003.

Additional key findings of the study include:

  • Prepayment penalties in subprime home loans increase the likelihood of foreclosure. Subprime home loans with prepayment penalties with terms of three years or longer faced 20 percent greater odds of entering foreclosure than loans without prepayment penalties. When these penalties were limited to a term of less than three years, the risk was slightly less elevated with borrowers facing 16 percent greater odds of foreclosure than their counterparts without prepayment penalties.

  • Balloon payments in subprime home loans increase the likelihood of foreclosure. Subprime home loans with balloon payments, where a single lump sum payment many times the regular payment amount is due at the end of the loan term, face 46 percent greater odds of entering foreclosure than loans without such a term.

  • Adjustable rates in subprime home loans increase the likelihood of foreclosure. Borrowers whose subprime loans include interest rates that fluctuate face 49 percent greater odds of entering foreclosure than borrowers with fixed-rate subprime mortgages.


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