Somewhere among the hundreds of pages of proposed consumer financial protection making its way through the House and Senate are provisions that may affect anyone who looks for a bad credit mortgage or subprime home loan. The new bills will give a new Consumer Finance Protection Agency (CFPA) the authority to abolish prepayment penalties on high-interest bad credit mortgages.

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Consumer advocates are all for this, claiming that the penalties keep those whose credit has improved trapped in mortgages with interest rates as much as five percent higher. If the law is passed, you'd be free to refinance out of a high-interest sub-prime mortgage the instant you qualify to do so.

This could end up costing you more, however. The reason that borrowers in subprime loans so often select loans with prepayment penalties is that the interest rates are much lower. The higher rates associated with loans that have no restriction on prepayment often push borrowers' debt-to-income ratios so high that they don't qualify for a mortgage. in this case, it's accept a prepayment penalty or don't get a loan. I have always advised in this blog that there is nothing wrong with a subprime ARM and a prepayment penalty as long as the penalty doesn't outlast the initial "teaser" rate. And as long as you have a plan for improving your credit so you can refinance to a better loan at the earliest opportunity.

Subprime crisis more an equity problem than a prepayment penalty problem. The cause of the sub-prime crisis was not prepayment penalties, it was housing values. Borrowers were unable to refinance before their subprime ARMs began adjusting to stratospheric heights because their home values dropped to the point where they couldn't qualify for a refinance no matter how much their credit had improved.

Borrowers should have a choice -- we're not a bunch of babies. As long as a penalty is properly disclosed, it should be available to those who want it. The across-the-board ban of this option will push bad credit interest rates up and cut off home ownership to those who could otherwise afford it. Not exactly the effect you want to have on a soft housing market.

There is another alternative. Products that reward borrowers who improve their credit or pay their mortgages on time have been around for a long time. Fannie Mae used to have one called Timely Payment Rewards that let borrowers with less-than-perfect credit qualify for an automatic rate reduction of up to 1 percentage point, based on credit history. To qualify, borrowers had to make payments on time for 24 months. Freddie Mac and other lenders had similar programs. It doesn't look like Fannie and Freddie will be getting back into the bad credit mortgage business any time soon, but today's subprime lenders should consider resurrecting their programs.