How to Avoid Mortgage Overcharges
October 3, 2005
Consumers overpay for a good or service either because the market is not fully competitive, or because the consumer does not have as much information as the seller. In the home mortgage market, overcharges are entirely related to lack of information by borrowers.
A while back, some large mortgage brokers let me see their pricing records covering a few months. Of 774 closed loans in the records, 516 or 2/3 involved overcharges, meaning that the borrower paid a price above the price posted by the brokers for their loan officers. These brokers operated in upscale neighborhoods and their clients were relatively sophisticated. I believe that in most other parts of the country, the percent of overcharges would be higher. Among sub-prime borrowers, it must be close to 100%.
To understand why mortgage overcharges are so pervasive, it is necessary to understand how this market works. Few do, because it is a curious amalgam of competitive practices employing modern technology, and the non-competitive practices of a camel bazaar.
The prices posted every day by retail lenders for their loan officers, and by wholesale lenders for their mortgage brokers, are very competitive. No retail lender can afford to disadvantage its loan officers by giving them prices noticeably higher than those of other retail lenders. Wholesale lenders are equally if not more careful, because they know that mortgage brokers routinely compare wholesale prices, and can easily move their business from one lender to another.
These "inside prices" are disseminated every morning, usually over the internet. They are strictly for the use of loan officers and mortgage brokers dealing directly with borrowers. I will use the term "loan officer", or LO, to mean both.
The non-competitive part of the process is the interplay between the LO and the borrower. The higher the price LOs can induce their customers to pay, the more they make on the deal. This part of the mortgage market is like a camel bazaar. The camel bazaar works better, however, because the information disadvantage of the buyer is smaller.
Camel buyers are generally experts about camels, and while they do not know as much about the particular camel being sold as the seller, they are free to examine the camel. Mortgage borrowers usually know very little about mortgages in general, and they can’t access the price sheets that would disclose the inside pricing of their particular loan.
The upshot is that the LO knows the competitive price and the borrower doesn’t. A "straight-arrow" LO – there are a few -- will quote the price on the price sheet. If a mortgage broker, the LO will add a reasonable target markup (perhaps 1 to 1.5 points) to the wholesale price and quote that price.
The price is not confirmed until locked in writing by the lender, and the market can change between the quote day and the lock day. When the lock day arrives, however, the straight arrow will use the same procedure to find the lock price that was used to find the earlier quote price. A retail price will come right off the price sheet and a wholesale price will carry the exact same markup.
If the LO is out to make as much on the deal as he can get away with, which is the pervasive practice, the price on the price sheet is only a starting point. If you are pegged as a dependent-type personality who knows very little about mortgages, has no inclination to shop and a strong inclination to trust, the quoted price will be high.
On the other hand, if the LO pegs you as a committed shopper, he may change his tactic to the exact opposite, quoting a price well below any legitimate price you might be quoted elsewhere. Of course, the LO has no intention of delivering this price, the sole purpose of the low-ball quote is to hook you -- start the lending process and turn you away from other loan providers.
The LO will warn you that the market is volatile and you will get the "market price" on the day you lock. When that day arrives, however, you discover that the market price is what the LO says it is!
If you are a house purchaser and there isn’t enough time before the closing to find a new LO, ouch, he has you. If you are refinancing to raise cash and eager to get it, your position may be almost as weak. If you are refinancing for other reasons, the LP will price based on an assessment of the likelihood that you will walk away or rescind the deal after closing.
In sum, most LOs overcharge mortgage borrowers because they can, and they can because LOs have critical pricing information borrowers do not have.
In some cases it does. I found that in a sample of upper-scale borrowers, who likely are more sophisticated than most, about 15% paid less than the inside price. The LOs in these cases had to share the shortfalls with their employers. But in 67% of the cases, the borrower paid more than the inside price. Competition at the point of sale is largely about which LOs borrowers select to overcharge them.
The bazaar discriminates against the gullible who believe that the price quoted to them is engraved in stone instead of being a whiff of smoke. It discriminates against the trusting who believe that the LO is serving the borrower’s interest instead of their own. But most of all, it discriminates against the passive who allow themselves to be solicited.
Consumers who find their LO by responding to solicitations pay the largest spreads over the inside price. They have to pay the costs of the solicitation, and they are least likely to understand the mortgage they are getting and the full terms of their deal. Soliciting LOs are prone to making outlandish claims as a way of hooking consumers who had not even been thinking about refinancing their mortgages. The best LOs live on referrals, they don’t have to spend time and money to acquire clients, and they don’t have to lie to them.
Inside pricing clearly does not. It is based on factors associated with risk of loss to the lender, including credit score, type of property, size of down payment, type of documentation and many other such factors. Race is never used in price setting.
In the mortgage bazaar, on the other hand, it would not surprise me if black borrowers had higher markups than white borrowers. Neither would it surprise me if they didn’t. Most LOs are equal-opportunity overchargers, meaning that they try to make as much as they can on every deal, whether the borrower is white or black. It is possible that, because of differences in cultures, they are more successful at this with blacks than with whites, but we don’t know. There are no data on markups classified by race.
[Parenthetical note: Data reported by lenders under the Home Mortgage Disclosure ACT, which do show black borrowers paying higher prices, reflect both inside pricing and the mortgage bazaar. This makes them irrelevant to the question of whether black borrowers are discriminated against.]
One approach is to master it, by learning enough to turn the tables on the LO. A number of pages on my web site are devoted to this topic.
Most mortgage borrowers, however, are not up to this. No matter how smart and aggressive you are, you are still an amateur playing against a pro. Especially if you are a home purchaser faced with a firm closing date, you have very little chance of coming out on top.
If you are refinancing and are smart and aggressive, you might possibly get the better of the LO. The right to rescind a refinance within 3 days of closing is a powerful bargaining chip for those who know how to use it. Most borrowers however, rather than trying to outwit the LO, prefer to avoid the bazaar. I believe this is wise -- learning how to select a good LO is a lot better investment than learning how to joust with a bad one.
One way to do this is to shop on-line among the better mortgage web sites, which I identify on my web site. There are no commission-incented LOs involved in on-line lending, only salaried employees who look to deliver loans at the prices posted on the sites.
A second way to avoid the bazaar is to retain a mortgage broker to act as your agent in finding a loan, paying the broker a set fee for the service. The broker passes through the wholesale price from the lender, so there is no haggling about the price of the mortgage. The borrower does have to negotiate the broker’s fee, but this much easier than negotiating the mortgage price. Brokers who operate this way, called Upfront Mortgage Brokers, are listed on my web site.
By far the best approach to avoiding the mortgage bazaar is to provide the borrower with his inside price, and let the borrower select a lender or broker who will provide the mortgage at that price plus a set or negotiated fee for service. This facility does not yet exist, but I’m working on it.
Consumers overpay for a good or service either because the market is not fully competitive, or because the consumer does not have as much information as the seller. In the home mortgage market, overcharges are entirely related to lack of information by borrowers.
Mortgage Overcharges Are Pervasive
A while back, some large mortgage brokers let me see their pricing records covering a few months. Of 774 closed loans in the records, 516 or 2/3 involved overcharges, meaning that the borrower paid a price above the price posted by the brokers for their loan officers. These brokers operated in upscale neighborhoods and their clients were relatively sophisticated. I believe that in most other parts of the country, the percent of overcharges would be higher. Among sub-prime borrowers, it must be close to 100%.
To understand why mortgage overcharges are so pervasive, it is necessary to understand how this market works. Few do, because it is a curious amalgam of competitive practices employing modern technology, and the non-competitive practices of a camel bazaar.
Pricing to Loan Officers is Highly Competitive
The prices posted every day by retail lenders for their loan officers, and by wholesale lenders for their mortgage brokers, are very competitive. No retail lender can afford to disadvantage its loan officers by giving them prices noticeably higher than those of other retail lenders. Wholesale lenders are equally if not more careful, because they know that mortgage brokers routinely compare wholesale prices, and can easily move their business from one lender to another.
These "inside prices" are disseminated every morning, usually over the internet. They are strictly for the use of loan officers and mortgage brokers dealing directly with borrowers. I will use the term "loan officer", or LO, to mean both.
Pricing to Borrowers Is Not Competitive
The non-competitive part of the process is the interplay between the LO and the borrower. The higher the price LOs can induce their customers to pay, the more they make on the deal. This part of the mortgage market is like a camel bazaar. The camel bazaar works better, however, because the information disadvantage of the buyer is smaller.
Camel buyers are generally experts about camels, and while they do not know as much about the particular camel being sold as the seller, they are free to examine the camel. Mortgage borrowers usually know very little about mortgages in general, and they can’t access the price sheets that would disclose the inside pricing of their particular loan.
The upshot is that the LO knows the competitive price and the borrower doesn’t. A "straight-arrow" LO – there are a few -- will quote the price on the price sheet. If a mortgage broker, the LO will add a reasonable target markup (perhaps 1 to 1.5 points) to the wholesale price and quote that price.
The price is not confirmed until locked in writing by the lender, and the market can change between the quote day and the lock day. When the lock day arrives, however, the straight arrow will use the same procedure to find the lock price that was used to find the earlier quote price. A retail price will come right off the price sheet and a wholesale price will carry the exact same markup.
If the LO is out to make as much on the deal as he can get away with, which is the pervasive practice, the price on the price sheet is only a starting point. If you are pegged as a dependent-type personality who knows very little about mortgages, has no inclination to shop and a strong inclination to trust, the quoted price will be high.
On the other hand, if the LO pegs you as a committed shopper, he may change his tactic to the exact opposite, quoting a price well below any legitimate price you might be quoted elsewhere. Of course, the LO has no intention of delivering this price, the sole purpose of the low-ball quote is to hook you -- start the lending process and turn you away from other loan providers.
The LO will warn you that the market is volatile and you will get the "market price" on the day you lock. When that day arrives, however, you discover that the market price is what the LO says it is!
If you are a house purchaser and there isn’t enough time before the closing to find a new LO, ouch, he has you. If you are refinancing to raise cash and eager to get it, your position may be almost as weak. If you are refinancing for other reasons, the LP will price based on an assessment of the likelihood that you will walk away or rescind the deal after closing.
In sum, most LOs overcharge mortgage borrowers because they can, and they can because LOs have critical pricing information borrowers do not have.
Why Doesn't Competition For Customers Drive Down the Price?
In some cases it does. I found that in a sample of upper-scale borrowers, who likely are more sophisticated than most, about 15% paid less than the inside price. The LOs in these cases had to share the shortfalls with their employers. But in 67% of the cases, the borrower paid more than the inside price. Competition at the point of sale is largely about which LOs borrowers select to overcharge them.
What Types of Borrowers Fare Poorly in the Mortgage Bazaar?
The bazaar discriminates against the gullible who believe that the price quoted to them is engraved in stone instead of being a whiff of smoke. It discriminates against the trusting who believe that the LO is serving the borrower’s interest instead of their own. But most of all, it discriminates against the passive who allow themselves to be solicited.
Consumers who find their LO by responding to solicitations pay the largest spreads over the inside price. They have to pay the costs of the solicitation, and they are least likely to understand the mortgage they are getting and the full terms of their deal. Soliciting LOs are prone to making outlandish claims as a way of hooking consumers who had not even been thinking about refinancing their mortgages. The best LOs live on referrals, they don’t have to spend time and money to acquire clients, and they don’t have to lie to them.
Does the Mortgage Bazaar Discriminate Against Minorities?
Inside pricing clearly does not. It is based on factors associated with risk of loss to the lender, including credit score, type of property, size of down payment, type of documentation and many other such factors. Race is never used in price setting.
In the mortgage bazaar, on the other hand, it would not surprise me if black borrowers had higher markups than white borrowers. Neither would it surprise me if they didn’t. Most LOs are equal-opportunity overchargers, meaning that they try to make as much as they can on every deal, whether the borrower is white or black. It is possible that, because of differences in cultures, they are more successful at this with blacks than with whites, but we don’t know. There are no data on markups classified by race.
[Parenthetical note: Data reported by lenders under the Home Mortgage Disclosure ACT, which do show black borrowers paying higher prices, reflect both inside pricing and the mortgage bazaar. This makes them irrelevant to the question of whether black borrowers are discriminated against.]
How Can Borrowers Deal With the Mortgage Bazaar?
One approach is to master it, by learning enough to turn the tables on the LO. A number of pages on my web site are devoted to this topic.
Most mortgage borrowers, however, are not up to this. No matter how smart and aggressive you are, you are still an amateur playing against a pro. Especially if you are a home purchaser faced with a firm closing date, you have very little chance of coming out on top.
If you are refinancing and are smart and aggressive, you might possibly get the better of the LO. The right to rescind a refinance within 3 days of closing is a powerful bargaining chip for those who know how to use it. Most borrowers however, rather than trying to outwit the LO, prefer to avoid the bazaar. I believe this is wise -- learning how to select a good LO is a lot better investment than learning how to joust with a bad one.
One way to do this is to shop on-line among the better mortgage web sites, which I identify on my web site. There are no commission-incented LOs involved in on-line lending, only salaried employees who look to deliver loans at the prices posted on the sites.
A second way to avoid the bazaar is to retain a mortgage broker to act as your agent in finding a loan, paying the broker a set fee for the service. The broker passes through the wholesale price from the lender, so there is no haggling about the price of the mortgage. The borrower does have to negotiate the broker’s fee, but this much easier than negotiating the mortgage price. Brokers who operate this way, called Upfront Mortgage Brokers, are listed on my web site.
By far the best approach to avoiding the mortgage bazaar is to provide the borrower with his inside price, and let the borrower select a lender or broker who will provide the mortgage at that price plus a set or negotiated fee for service. This facility does not yet exist, but I’m working on it.