Mike Roberts is about to make his first early payoff (EPO) penalty in two years after finding out that one of his clients refinanced a $355,000 loan with a 7.25% rate that Roberts closed in April.
“The amount that we received in yield spread was 1.72%, which equates to $6,106,” said Roberts, co-founder and president of City Creek Mortgage. “He didn’t refi with us, so we are not making back money. We are giving back the money we earned. It’s a pure loss. If they came back to us, we would have gotten the revenue to offset the EPO. But in this case it is a straight-up loss.”
An EPO penalty kicks in for the originating lender when a borrower pays off their mortgage earlier than the agreed-upon term in the lender contract. EPOs are intended to guarantee a minimum return for the investor or mortgage aggregator if a loan is paid off in the first few months.
Each investor has their own time frame for EPO fees, but they generally range from three to six months. For instance, if a lender sold a loan to Fannie Mae or Freddie Mac and the mortgage was paid off less than 120 days from the time it was sold, the lender would refund the premium that Fannie or Freddie paid for the loan.
“As rates start to come down, EPOs get to be a very edgy, very contentious issue for companies, their sales force, the investors who are buying these loans,” said Brian Hale, founder and CEO of Mortgage Advisory Partners.
With mortgage rates rising for much of the past two years, EPO fees were one of the last things to worry about for mortgage lenders. But as rates have been on a declining trend since reaching 7.5% this past spring, some lenders are being penalized as homeowners refinance into loans in the 6s.
“It’s already happening. Rates were in the mid- to low 7% in March and April, so those people are already in the money,” said Jon Overfelt, owner of American Security Mortgage Corp.
“And where we see it happening a lot now is a borrower using a regular loan as a bridge loan. A homeowner wants to buy another house; they haven’t sold their current home. So, they go ahead and sell their current home, and then they either pay off the mortgage they just got from us or they pay it down rapidly,” he added.
When mortgage rates drop rapidly, EPOs jump significantly as homeowners rush to refinance their mortgages while the EPO window is still open. While the pace of mortgage rate declines is hard to predict, lenders are strategizing for how to minimize the hit when the next refi boom comes.
Who will be hit hardest?
Loan originators are some of the players most exposed to EPO expenses.
Some mortgage lenders note in the loan originator compensation agreement that if the lender must pay an EPO fee, it has the right to reclaim the LO’s commission. Depending on the state, the company would have the ability to recoup up to 100% of that amount.
“There’s nothing more demotivating than EPOs. Not only do EPO penalties hit the company, but that transfers that right to the LO and claws back their commission,” said Michael Clark, vice president of Primary Residential Mortgage Inc.
While originators at Clark’s branches are not responsible for these fees when borrowers refi within the EPO window, he foresees a wave of penalties as refi shops have started to offer lower rates to court customers.
“I’m seeing it already. I’m seeing it in the pricing,” Clark said. “There’s a ton of different coupons in both the FHA, VA loans and high-balance conventional mortgages that refi shops are taking a little bit of a hit on right now to get it on their portfolio so they can turn around and refinance it. They’re timing it.”
EPO fees can fluctuate based on the loan size and what the aggregator paid for the loan, but they generally range from 1% to 5% of the loan amount.
For companies that retain servicing, lenders will write off the unamortized value of the loan if it pays off early.
“Where there’s a potential challenge would be if you’re selling a loan at a large premium,” said Ben Hunsaker, head of structured credit at Beach Point Capital Management. “I’d say you (lenders) sell on 104% of par, 105$ of par, and you’re giving the loan buyer early prepayment protection, meaning you’ll give them cash for the difference between par and the premium they paid if the loan pays off early. That’s where it can start to be like a cash constraint for the lenders.”
EPO fees can erase all profits that the originating lender earned on the loan and may even result in thousands of dollars in additional fees, an especially costly detriment to small lenders.
While many lenders have access to software that aggregates the information of potential refi candidates, lenders without a servicing portfolio may not have the systems in place to reach out to these clients more quickly.
“Lenders who retain MSR (mortgage servicing rights) have more recapture capability visibility. When a borrower has their credit pulled for a mortgage refinance application, the servicer is going to see that and have the opportunity to earn the economics of that customer,” Hunsaker said.
Lender strategies against penalties
When lenders sell loans to investors or mortgage aggregators, paying close attention to the EPO provisions in the loan sale agreements is key so that the penalties don’t come as a surprise. Lenders should negotiate what the EPO penalties will be and how they will be enforced.
Some investors will waive EPO penalties for a lender in exchange for the lender sending them a bulk of their volume. Oftentimes, the investor does not pay market rate for these loans, so in effect, the lender might end up paying the penalty through lower revenue.
“Some very smart folks who make good loans and sell a lot of volume to the aggregator either negotiate shorter EPO periods or a reduction in the penalty of the amount that they can be charged on a per loan basis,” Hale said.
Removing language around the investor having sole discretion over buying loans will protect the lender, especially when rates go up, since the investor can choose to buy fewer loans. Another strategy is to price significant hits into any purchase by an investor with an EPO period longer than the agencies.
“For example, an investor can tell us to price in 5 basis points (bps) if we have a higher EPO than other investors. That may be fine in a normal market,” one lender said. “But in a volatile market like today, that difference of having another 60 days for the EPO window and having to pay back all the premium, that’s more like paying 150 to 200 bps.”
Companies often do not position their secondary teams to value the differences in EPO periods between investors, especially in more volatile markets. In normal times, these differences may be much smaller, the lender explained.
The rule of thumb when it comes to EPOs is to close the deal and take the money. The risk is that the EPO fee may cancel out the revenue from a new loan — if the lender is able to recapture the borrower at all — originators and industry experts said.
“Clearly, if the client has a need and you can fulfill it, you sometimes just have to do it because otherwise they’re going to find someone else to do it and you’re still going to get the EPO,” said Geoff Black, senior loan consultant at Guild Mortgage. “So, your choice is to do it and get compensated on the new loan while you get a clawback on the old loan. So, you end up even. It’s totally a retention move.”
