Why Small Loans Are a Problem

Providing small loans at affordable prices has always been a challenge. The core problem is that the cost of originating and servicing a loan is much the same for a small loan as for a large one but the interest return, based on the loan amount, is smaller on the smaller loan. The obvious remedy, a higher interest rate on the smaller loan, makes it costly and perhaps unaffordable.

The price sheets of lenders in the US generally show higher first mortgage rates on smaller loans, with minimum sizes ranging from $50,000 to $75,000. Who needs a mortgage of less than $50,000? For one, people who live in isolated communities where houses are very inexpensive.

The Problem of the Small Isolated Town

"In my town, we need mortgage loans from $5,000 to $30,000, and they just aren’t available. Is there anything that can be done?"

The town is Winters, Texas, population about 3,000 most of whom are retirees. There are no jobs there or anywhere very close. Houses in Winters sell for less than $60,000.

Mortgage loans are not available in Winters. In part, this is because the town is so isolated and the demand so small that it can’t support a lending facility. There are no appraisers, for example; if one is needed the cost will be double the cost in a larger center because of the time it takes for the appraiser to get to Winters and back.

But the major problem is that the loans are too small to justify the cost of originating them. A mortgage origination cost of $5,000, which is a very modest number, is 10% of a $50,000 loan, though only 1.7% of a $300,000 loan.

The Problem of Refinancing Small Loans

Another category of borrowers vulnerable to the small loan problem are those who have paid their loans down substantially and would like to take advantage of lower interest rates by refinancing.

"I have a 10% loan from way back, should have refinanced years ago, balance is only $42,000 now, is it too late?"

Of course, it is too late. No lender wants to refinance a $42,000 loan unless it is a substantial cash-out where the new loan is much larger than the balance of the old one.

On cash-out deals where the balance and new loan amount is large but the amount of cash taken out is small, the small loan problem hits the borrower but not the lender. A reader recently described a deal in which she refinanced a $110,000 loan at 6.75% into a $122,000 loan at 7%. Of the $12,000 increase in the balance, $4500 was the cash she took out and $7500 was closing costs including the broker’s fee.

On this loan, the lender spread his costs over a $122,000 loan but the borrower’s cost of $12,000 was incurred to obtain cash of only $4500. Plus the borrower is now paying a rate ¼% higher than before on $110,000. Assuming she holds the loan for 5 years, her annual interest cost on the $4500 is 32%.

Cash-out refinances for small amounts are almost always more costly than a second mortgage. In the case above, a second mortgage at any rate below 32% would have saved her money. Indeed, she might possibly have done better in the unsecured loan market.

The great majority of loans for amounts of less than $50,000 are second mortgages or unsecured. The development of the internet has widened borrower choice in the unsecured market enormously – at least among those who use computers. (For the others, small loan offices are still found in many shopping centers.) Residents of Winters, Texas should forget about getting mortgages and shop for unsecured loans on the internet.

Is Prosper.com an Answer?

A relatively recent on-line entrant into the unsecured loan market, www.prosper.com, is particularly interesting. I have spent hours on their web site and have been enormously impressed.

Prosper brings potential borrowers and lenders together in a virtual market that appears to provide an attractive return to lenders and a reasonable cost to borrowers. Lenders (of which I will shortly be one) are given extensive information about borrowers, including credit information and referrals. They can lend as little as $100 on any one deal, which allows them to diversify their risk without committing larger sums. Because it is a virtual market, borrowers can live anywhere, even in Winters.

Prosper charges a reasonable origination and servicing fee for doing all the spade work: compiling borrower information, collecting the payments, keeping the books, and pursuing delinquent borrowers. I expect to have a fuller report on them in the near future.

Copyright Jack Guttentag 2007

SHOULD MORTGAGE ESCROWS BE MANDATORY?

July 2, 2007

Mortgages Are Generally Priced on the Assumption That the Borrower Will Escrow

With one important exception, lenders price loans on the assumption that borrowers will include taxes and insurance premiums in their monthly mortgage payments. These payments are placed in an escrow account under the lender’s control. On a payment date, the amount due is paid by the lender.

The escrow requirement protects the lender. If the taxes are not paid, the tax authority could place a lien on the property that would have a higher priority than the lender's lien. Similarly, if the insurance premiums are not paid and the house burns down or is flooded away, the lender's protection goes with it.

Escrow is not an absolute requirement. Borrowers who want to pay their own taxes and insurance can waive the requirement by paying a modest fee. Most borrowers offered the choice accept the escrow, I suspect less to save the fee than because they find that the payment discipline is useful. I escrowed on both my mortgages because it simplified my life.

Sub-Prime Loans Usually Don't Carry Escrows

In the sub-prime market, however, most borrowers are not offered the choice. They need not pay a fee to have the requirement waived because there is no requirement. In this market, loans are sold to relatively unsophisticated borrowers on the basis of payments, which are lower when they don’t include escrows. Lenders who insisted on escrows would lose business to those who didn’t.

The upshot is that borrowers who have shown themselves to be the least capable of managing their credit affairs, who are most in need of the discipline provided by the escrow system, don’t have it offered to them.

With the recent jump in sub-prime foreclosures, this feature of the sub-prime market has emerged as one contributor to the problem. Legislators hearing about it are understandably outraged. The response of some is to propose that escrows be mandated by law on all mortgages.

Mandating Escrows Carries Risks to Borrowers

In deliberating this idea, lawmakers should understand that the firms who manage escrow accounts, call them "servicing agents", or SAs, sometimes abuse borrowers for profit. SAs are not selected by borrowers, and cannot be fired by them no matter how much harm they cause the borrower. Further, when SAs manage a borrower’s escrow account, the potential harm they can cause increases substantially.

For one thing, SA systems sometimes fail and the borrower’s tax and insurance payments don't get made. (See Advantages and Disadvantages of Mortgage Escrows). Because some SAs don’t disclose the payments they make, or don’t make, on a current basis, borrowers can be in the dark for an extended period before they discover that the SA has screwed-up. (See Should All Borrowers Receive Monthly Statements). Meanwhile, they may find themselves with a cancelled insurance policy or a tax lien on their property.

I have heard many horror stories of this type directly from borrowers. Outside of legal action against the SA, which few borrowers can afford, they have no effective recourse. Borrowers who pay a fee to waive escrows often do it to avoid this risk.

A second risk arises in connection with an increase in the required escrow payment, which the borrower, for any number of reasons including lack of proper disclosure by the SA, fails to make. Many SAs in this situation place the entire payment in a suspense account and mark the borrower delinquent. This pernicious practice results in unnecessary delinquencies and late payments, and can lead down a slippery slope to collections and ultimate foreclosure.

Unfortunately, to make escrows the norm in the sub-prime market requires that escrows be made mandatory for all mortgage borrowers. Escrows can’t be required for "sub-prime" loans only because that term can’t be precisely defined. And if the law only required that escrows be "offered" to borrowers, it would be sabotaged by loan officers and mortgage brokers.

But the requirement could be short. Its purpose is to force borrowers at the outset to confront their ability to afford the major expenses of home ownership, and this purpose would be served by an escrow requirement that applied only to the first year. After that, borrowers should be allowed to opt out if they want to.

A Law Mandating Escrows Should Require a Quid Pro Quo From Servicing Agents

But to require borrowers to escrow, even if only for a year, without protecting them against escrow abuses by SAs, would be irresponsible. SAs should be required to provide easy-to-understand monthly statements showing everything that transpired during the month that affected the borrower’s account. This should include payments out of and credits to escrow, balance changes and their sources, rate adjustments, and fees. In addition, SAs should be prohibited from placing scheduled payments of principal and interest in suspense accounts when only the escrow payment is short.

June 18, 2007

BANK OF AMERICA'S NO FEE MORTGAGE PLUS PROGRAM

What Is No Fee Mortgage Plus?

Bank of America’s new No Fee Mortgage Plus (NFMP) program for home purchasers collapses all lender fees into one combination of interest rate and points, eliminating the myriad of separate lender "junk fees" that confuse shoppers. Junk fees are also a source of abuse by less scrupulous lenders who may raise them at the 11^th hour.

B of A is not unique in eliminating junk fees. Upfront Mortgage Lenders (UMLS, there are now 4 listed on this site) also commit to a single guaranteed fee, as does ABN AMRO. But B of A is the largest, and hopefully it will induce other large players to follow suit.

An even more impressive feature of NFMP is its absorption of all private third-party charges, including title insurance, mortgage insurance, appraisal costs and credit report. B of A includes third party costs as well as its own costs in its rate and points.

The only other lender that does this is ABN AMRO, but B of A goes a step further in absorbing mortgage insurance charges on loans with down payments of less than 20%. AMRO passes the cost of mortgage insurance to the borrower, as do all other lenders. In addition, while both firms absorb the cost of lender title insurance policies, B of A also pays for the buyer’s title policy.

Are NFMP Loans a Good Deal?

Of course, B of A must cover third party costs in its own single fee, so NFMP loans aren’t necessarily bargains. Unfortunately, whether or not NFMP loans are a good deal for borrowers is far from clear. The only way to shop one lender against another effectively is on-line, and B of A makes this very difficult.

Their web site is designed to induce you to call them, not shop them. To find prices, you have to learn that the "Calculator" button provides the path, which takes some doing. When you get there, you find that B of A has narrowed your selection to only 3 combinations of interest rate and points for each of 7 programs. (Good web sites offer as many as 10 times that number). This winnowing down of choices might be acceptable, even desirable, if it were based on relevant borrower characteristics, such as their expected period in the house, or their tax bracket, but it isn’t.

Further, you can’t shop adjustable rate mortgages (ARMs) with confidence because the site does not disclose the index, margin, rate caps or maximum rate. And borrowers who cannot provide full documentation, or whose credit is not "good", can’t price their loans on the B of A site because the site does not adjust prices for these factors.

I worked within these limitations to compare B of A’s prices with those of a UML which discloses a very wide range of rates that allowed me to find matches for the few rates shown by B of A. In the comparisons, I selected common interest rates and compared the B of A points with the sum of lender fees and third party fees at the UML.

The results were mixed. In the 11 comparisons I did, B of A’s prices were lower in 5 and higher in 6.

The bottom line is that B of A’s inclusion of all lender junk fees and third party fees into a single price does not necessarily mean that a B of A price is lower than that of its competitors. It all depends on the particular market niche in which the borrower falls, and B of A’s price in many if not most niches can’t be shopped on-line.

B of A’s loan officers still have the right to charge an overage – a price higher than the price posted by the company. Overages and price secrecy are vestiges of the bazaar culture that has long dominated mortgage banking. B of A has taken a big step away from the bazaar, but it still has a way to go.

Will the Bank of America Model Be Copied?

If B of A’s example is followed by other lenders, or if it emboldens legislators to mandate it for all lenders which I have long advocated, its importance cannot be overemphasized.

Under existing arrangements where borrowers pay the third party fees, lenders have had no incentive to use their buying power to lower them. But once lenders are on the hook for these charges while competing with each other for loans, they will use their superior information and buying power to drive down prices. The incremental cost of third party services included in the lender’s price will be much lower than the prices borrowers now pay when purchasing them separately.

HOW SHOULD BORROWERS DEAL WITH MORTGAGE BROKERS?

June 18, 2007

Borrowers who don’t know how to deal with mortgage brokers waste their own time as well as that of the brokers. Borrower ignorance also encourages brokers to be hustlers rather than professionals.

In general, borrowers should view brokers as providers of professional services for which they are paid a fee. That fee is the only price brokers control, and it is the only price that borrowers using brokers should shop.

Shopping Rates and Points With Brokers Is a Waste of Time.

To provide accurate price quotes, brokers need to know many things about the borrower, the property and the transaction. This information must then be matched against the prices contained in voluminous price sheets the brokers receive every day from multiple lenders. This is a lot of work, and few brokers will do it for casual rate shoppers.

Brokers in this situation typically quote the best price possible – if the information required to price accurately is not used, this price is as good as any other. Some brokers will go even further and price below the best price possible, a practice know as "low-balling." The intent is to encourage the shopper to select the low-balling broker, who if successful will later find ways to raise the price.

But even if borrowers receive accurate price quotes from brokers, price shopping is usually a waste of time. The market is so volatile that prices can change once or more before the day is over, and they will always be reset the following morning. The only effective way to price shop is to do it on-line, where borrowers can compare quotes from multiple lenders within minutes of each other.

Borrowers should engage mortgage brokers in the same way that they engage other service providers, such as lawyers, architects or house painters: by assessing their ability to do the job effectively, the fee they charge for their services, and their guarantees or other assurances.

Assessing Brokers’ Ability to Help

Brokers should be interviewed about their qualifications and experience in the same way you would interview any other service provider. Engage the broker in a dialogue regarding your problem, and assess the response. Does this broker listen and respond thoughtfully? Or do you have the feeling he is trying to shoehorn you into something whether it fits or not?

You should also ask whether the broker will commit to a fee set in advance, and whether any guarantees are provided. Broker practice with regard to third party services is a particularly telling indicator of service quality (see below).

Pricing the Broker’s Services

The fee for the broker’s services should be agreed to by both parties, in advance and in writing. If there is a separate processing fee, it should be included in the agreement. Upfront Mortgage Brokers follow these rules as a matter of course, and most other brokers will as well if the borrower insists on it. Don’t waste any more of your time on a broker who refuses.

The broker’s fee may be paid by you, by the lender, or by both. The fee is a negotiated item, but determining whether the fee will be paid by you or by the lender should be your decision alone. If you are short of cash and/or don’t expect to have the house very long, you may want to pay a slightly higher interest rate in order to have the lender pay the broker’s fee. If you have a long time horizon and enough cash, pay the broker yourself in order to get the lower rate.

Broker Guarantees

Upfront Mortgage Brokers provide four guarantees to borrowers that all brokers can and would provide if borrowers insisted on them.

The broker’s total income from the transaction will not exceed the fee agreed upon with the borrower, as discussed above.
The broker will provide the borrower with a copy of the rate lock commitment from the lender as soon as it is received. This prevents the broker from substituting her own lock for the lender’s, a practice that puts a few additional dollars in the broker’s pocket but leaves the borrower unprotected against a serious spike in interest rates.
The fixed-dollar lender charges shown on the Good Faith Estimate, which are usually not part of the lock commitment, will not be changed so long as the transaction is not changed.
Third party fees will be passed along with no direct or indirect markup by the broker.

Some brokers go beyond strict neutrality on third party services, negotiating preferential prices with service providers and/or guaranteeing third party charges. Brokers who do either are very likely to be superior in other dimensions of service as well.