Q: Why can't we simply arrange new financing, cease payment on the old loan, and pay off in full when the lender forecloses?
A: Your suggestion to let the loan go to default, and then at the foreclosure proceeding pay the original lender in full without penalty is ingenious. I doubt that this would work, however.
No new lender will be willing to go along with this procedure, since there would not be a clean first lien on your property until the prepayment penalty is paid.
When a mortgage lending institution commits funds, it insists on a clean and clear title so that if it must foreclose it will be in a top priority position. Generally speaking, the only way to clear up the first lien from your original lender is to have a release of the original deed of trust filed in the appropriate land records office.
In order to obtain such a release, the original note must be marked "paid and cancelled" by the original lender. As a general rule, no mortgage lender will be willing to release its lien until it has been paid in full -- including any prepayment penalty.
Foreclosure should be the last resort for the lender and the borrower, and should not be undertaken casually.
Unsually, the lender will be more than willing to cooperate with the borrower to avoid foreclosure, until all other avenues of relief have been exhausted.
When you purchased your house, you signed a deed of trust. In effect, you deeded the property "in trust" to trustees selected by the lender. If and when you pay off your mortgage, the trustees will release their security from the land records. If, on the other hand, you do not make payment, the trustees can be directed to institute foreclosure proceedings. After advertising the property for a period of time, the trustees are authorized by law to sell your house to the highest bidder at a foreclosure sale.
I don't recommend anyone to go through foreclosure proceedings. First, your credit rating will be hurt.
Second, the standard form deeds of trust require you to pay trustee fees and attorney fees in connection with the foreclosure proceedings. The fees can be high. Additionally, the advertising costs and other expenses incurred in connection with the foreclosure will be deducted from the gross proceeds at a foreclosure sale.
Finally, you run the risk that your house will be sold out from under you, at a price considerably lower than the market value.