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The impact of predatory loan terms on subprime foreclosures: The special case of prepayment penalties and balloon payments

Abstract There are growing concerns about the way predatory mortgages erode housing equity. We examine another potential 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 use a national database of subprime refinance first‐lien loans originated in 1999 to analyze this question. Even after we control for other factors, refinance loans with prepayment penalties are 20 percent more likely and those with balloon payments are 50 percent more likely to experience a foreclosure than other loans. These findings suggest that predatory loans have the potential not only to erode household wealth, but also to heighten negative effects on individuals, households, and communities. Excluding losses to borrowers, we estimate that prepayment penalties and balloon payment requirements in 1999 refinance originations increased national foreclosure‐related losses to lenders and investors by about $465 and $127 million, respectively.