A Better Approach to Yield Spread Premiums?
April 22, 2002
"I read recently that HUD is not going to adopt proposals for requiring effective disclosure of yield spread premiums. Is there any other way of dealing with the problem that doesn’t involve throwing out the baby with the dirty bathwater?"
There is a way, and I’ll get to it after explaining what the baby and the dirty bathwater are.
Yield spread premiums (YSPs) are points paid by lenders to mortgage brokers for delivering high interest rate loans. Points are an upfront charge expressed as a percent of the loan. On low-rate loans, lenders charge points whereas on high-rate loans, lenders pay points.
For example, a lender offering a 30-year fixed-rate mortgage at 7% and zero points might charge 2 points for a 6.50% loan, and might pay 1.5 points for a 7.50% loan. The 1.5 points paid by the lender is the YSP.
The baby that deserves protection is the flexibility that YSPs provide to some borrowers. YSPs enable borrowers with little cash to obtain no-cost mortgages, on which settlement costs are paid by the lender. And borrowers who expect to live in their homes for only a few years find it advantageous to reduce their upfront fees by paying a higher rate.
The dirty bath water that policy-makers would like to throw away are the borrower overcharges associated with YSPs. Mortgage brokers know what the YSPs are in the wholesale prices quoted by a lender, but the borrower does not. Most brokers keep the lender prices under lock and key. The exceptions are Upfront Mortgage Brokers (UMBs), who reveal lenders’ wholesale prices at the borrower’s request.
A borrower is much less likely to question a mortgage broker’s fee if the fee is paid by the lender rather than out of the borrower’s own pocket. Even borrowers who realize that they ultimately pay the YSP in the interest rate are less concerned because the burden is deferred.
The disclosure remedy to this problem I have long advocated is that HUD require brokers to declare their compensation from both the borrower and the lender, in writing, before submitting an application to a lender. But the prospects for such action now seem dim.
Fortunately there is another approach, suggested to me by Steve Wheeler, a UMB from California. It could be deployed by lenders on their own, if they can muster the will.
Lenders can simply credit YSPs to borrowers rather than to brokers. All payments to brokers would be made by borrowers, from their own funds or from YSP credits. Borrowers would then effectively control broker compensation, which is as it should be.
Since the borrower pays for a YSP in a higher interest rate, it makes no sense for the payment to be made to the broker. Brokers dealing with uninformed borrowers are incented to feed as little of it back as possible. The YSP should be credited directly to the borrower, who can then pay the broker as agreed to by the parties.
In many purchase transactions, especially those involving FHA mortgages, the house seller makes a contribution to the buyer’s settlement costs out of the proceeds of the sale. At closing, the escrow agent allocates this money to the buyer’s costs. If seller contributions were handled in the same way as YSPs, they would first be allocated to the real estate agent, who then might or might not credit some of it to defray the agent’s commission. No one, not even real estate agents, would defend such an arrangement. YSPs can and should be treated in the same way as seller contributions.
"I read recently that HUD is not going to adopt proposals for requiring effective disclosure of yield spread premiums. Is there any other way of dealing with the problem that doesn’t involve throwing out the baby with the dirty bathwater?"
There is a way, and I’ll get to it after explaining what the baby and the dirty bathwater are.
Yield spread premiums (YSPs) are points paid by lenders to mortgage brokers for delivering high interest rate loans. Points are an upfront charge expressed as a percent of the loan. On low-rate loans, lenders charge points whereas on high-rate loans, lenders pay points.
For example, a lender offering a 30-year fixed-rate mortgage at 7% and zero points might charge 2 points for a 6.50% loan, and might pay 1.5 points for a 7.50% loan. The 1.5 points paid by the lender is the YSP.
The baby that deserves protection is the flexibility that YSPs provide to some borrowers. YSPs enable borrowers with little cash to obtain no-cost mortgages, on which settlement costs are paid by the lender. And borrowers who expect to live in their homes for only a few years find it advantageous to reduce their upfront fees by paying a higher rate.
The dirty bath water that policy-makers would like to throw away are the borrower overcharges associated with YSPs. Mortgage brokers know what the YSPs are in the wholesale prices quoted by a lender, but the borrower does not. Most brokers keep the lender prices under lock and key. The exceptions are Upfront Mortgage Brokers (UMBs), who reveal lenders’ wholesale prices at the borrower’s request.
A borrower is much less likely to question a mortgage broker’s fee if the fee is paid by the lender rather than out of the borrower’s own pocket. Even borrowers who realize that they ultimately pay the YSP in the interest rate are less concerned because the burden is deferred.
The disclosure remedy to this problem I have long advocated is that HUD require brokers to declare their compensation from both the borrower and the lender, in writing, before submitting an application to a lender. But the prospects for such action now seem dim.
Fortunately there is another approach, suggested to me by Steve Wheeler, a UMB from California. It could be deployed by lenders on their own, if they can muster the will.
Lenders can simply credit YSPs to borrowers rather than to brokers. All payments to brokers would be made by borrowers, from their own funds or from YSP credits. Borrowers would then effectively control broker compensation, which is as it should be.
Since the borrower pays for a YSP in a higher interest rate, it makes no sense for the payment to be made to the broker. Brokers dealing with uninformed borrowers are incented to feed as little of it back as possible. The YSP should be credited directly to the borrower, who can then pay the broker as agreed to by the parties.
In many purchase transactions, especially those involving FHA mortgages, the house seller makes a contribution to the buyer’s settlement costs out of the proceeds of the sale. At closing, the escrow agent allocates this money to the buyer’s costs. If seller contributions were handled in the same way as YSPs, they would first be allocated to the real estate agent, who then might or might not credit some of it to defray the agent’s commission. No one, not even real estate agents, would defend such an arrangement. YSPs can and should be treated in the same way as seller contributions.