Mortgage- and Lender-Related Settlement Costs

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1 Mortgage- and Lender-Related Settlement Costs Most people associate settlement costs with mortgage loan charges which take place when a real estate mortgage closing is funded. These fees and charges vary; and in the following material, we will try to explain them in plain English with some examples. Application fee Imposed by a lender or broker, this charge covers the initial costs of processing a loan request and checking the client s credit report. (Although sometimes the credit report can be a separate expense imposed when a broker initially starts to price out a loan) Estimated cost: $75 to $300, including the cost of the credit report for each applicant Loan origination fee The origination fee is charged for the lender or mortgage broker s work in evaluating and preparing a mortgage loan. This fee is usually an additional fee mortgage brokers add to the loan to increase the amount of money made on the loan. To many, origination fees are a touchy subject since some categorize them as pure profit for a broker who might be being paid on the back end of the loan as well. High cost mortgages may sometimes have several points charged and in some cases require extra disclosures as a result. This is explained in further detail in a later section. Estimated cost: 1% to 2% of the loan amount PAR The PAR rate is the rate at which the lender charges to lend money in the open market. To have a loan at PAR would be considered a no-cost loan to the consumer. By no cost, that does not mean the borrower will get out of paying other typical closing costs. It simply means that a loan broker did not add up-front or back-end points to the cost of the loan. In actuality, an at-par loan is more like a no-income loan for the mortgage broker. Copyright 2006, The Wealth Preservation Institute ( 1

2 PAR on a rate sheet a mortgage broker uses to find the daily interest rate is identified by using a 100 point scale. In the following chart, you ll see that the PAR interest rate is 5.750%. If there are points paid to buy down the interest rate, the borrower will have a cost; and in the following chart, the cost would be 1% of the loan value. If the broker would like to be paid as is normally the case on the back end, the loan would be above PAR; and in the following chart, the 1% above par rate is 5.875%. Both points and back-end payment to mortgage brokers will be explained in upcoming sections % 101 YSP 5.750% 100 PAR 5.50% 99 Cost A mortgage broker wouldn t be a broker very long doing PAR loans with no front- and back-end loads. Rebate (points) or Yield Spread Premium, or YSP, is the cash rebate paid to a mortgage broker based on selling an interest rate above the wholesale PAR rate that the borrower qualifies for. In the above chart, you ll notice YSP in the right hand column. In the chart, if a mortgage broker offers a borrower a loan of $100,000 at an interest rate of 5.875% and the PAR rate is 5.750%, the broker may earn a Yield Spread Premium (YSP) equal to 1.0% of the loan amount. This $1,000 fee is paid by the lender directly to the broker as a "rebate." The mortgage broker earns "one point" directly from the lender "POC" (Paid outside Closing or on the back end). Although the borrower is not charged the fee directly, the borrower does pay the fee indirectly by accepting a higher interest rate in exchange for lower up-front fees. In the U.S., mortgage brokers (vs. W-2 employees who work directly for the lender) are required to disclose YSP as a fee "POC" (Paid Outside Closing) on page 2 of the HUD1 Settlement statement, inside the margin, away from the column marked "Paid from Borrower's funds at Settlement." YSPs as a financial instrument are not controversial. This is standard operating procedure for how lenders allow mortgage brokers to lend money in the open market. Conventional mortgage brokers contend that this disclosure requirement puts them at a disadvantage when compared to Institutional ("Retail") Lenders, who do not have to disclose their YSP. In addition, they point out that there are truly legitimate reasons for a YSP, such as help in offsetting closing costs for borrowers who are short of cash. For those borrowers, brokers use the YSP to help pay closing costs. Conventional mortgage brokers also point out that, if only Copyright 2006, The Wealth Preservation Institute ( 2

3 they were required to disclose their YSP, borrowers might not save money but are simply steered to retail lenders who would charge the same amount for a loan (which would appear better at first glance because they did not have to list those fees explicitly). As with any fee issue, the Wealth Preservation Institute s stance on it is simple - every advisor has to make a living and needs to be paid for work done. The key is to keep fees in line with the industry standard, to be open and honest with the client, and to make sure you are not taking advantage of someone who does not understand the transaction. Points (also known as Loan Discount Fee or Origination Fees) Points are a one-time charge imposed by the lender, usually to reduce the interest rate of a loan. One point equals 1% of the loan amount. For example, 1 point on a $100,000 loan would be $1,000. In some cases, especially in refinancing, the points can be financed by adding them to the amount that is borrowed. However, if the points are paid at settlement, they are deductible on a client s income taxes in the year they are paid (different deduction rules apply when refinancing or purchasing a second home). The following is what a real-world interest rate sheet looks like when a mortgage broker pulls rates for a prospective client % YSP 6.125% YSP 6.000% YSP 5.875% YSP 5.750% Close to PAR 5.625% Cost 5.500% Cost In the chart, you will see a list of interest rates on the left, in the center numbers that go up and down using 100 as the PAR rate, and on the right, you will see YSP (yield spread premium), PAR, or, in this case, Close to PAR and Cost. The term cost in the chart is the amount of up-front money (as a percentage of the loan) the client would have to pay in cash to receive a lower long-term interest rate on a loan. Copyright 2006, The Wealth Preservation Institute ( 3

4 To determine the actual up front point costs, you simply take the numbers in the center column below the PAR amount and subtract 100 (or in this case which is as close to PAR as the sheet can come. Therefore, it would cost the client, using the above chart, 1.47% ( ) of the initial loan balance to buy down the interest rate from 5.75% to 5.5%. The cost at closing would be $5,880 on a $400,000 loan. The good thing about up-front costs at a closing is that they can be fully deductible in the year incurred given the right circumstances. Estimated cost when paying up-front points or a loan discount fee: 0% to 3% of the loan amount Back-End Profits of Mortgage Brokers As we ve briefly discussed, when we talk about back-end profits of mortgage brokers, we are discussing the income a broker makes not from charging the client up-front fees but instead what the broker makes on the backend by being paid from the lender who ultimately funds the loan. As just discussed, the back-end profit comes from the YSP or rebate. Let s use the same real world rate sheet for an illustration. The following is for a 30-year conventional mortgage. The rate is in the left-hand column which changes depending on how the broker prices the loan. The center column works up and down from the PAR rate which is normally thought of as 100, but, in most cases will be slightly higher or lower in a real-world rate sheet. When the rate is above 100, those are the origination/rebate fees which are generated so that the lender can pay the mortgage broker on the back end. When pricing a loan from this sheet at as close to PAR as we can get it, the number creates a $366 broker fee on a $100,000 loan. A 2% YSP/rebate would actually be in the spreadsheet. If the broker priced the loan at 6.250%, the broker fee on the back end would be $2,006 on a $100,000 loan and $8,024 on a $400,000 loan % YSP 6.125% YSP 6.000% YSP 5.875% YSP 5.750% Close to Par 5.625% Cost 5.500% Cost Copyright 2006, The Wealth Preservation Institute ( 4

5 As we discussed, rate sheets have below-par rates on them. Those rates in this sheet are 5.625% and 5.500%. This means the broker is making no back-end points and will only derive income from other fees that are charged at the closing. Deleted: In the above sheet, it would cost the client 1.47% ( ) of the loan balance as a pre-pay cost to buy down to the 5.50% interest rate. That number is not reflective of what the actual closing costs of the loan will be. Remember, at PAR or below loans, the broker makes NO money. Therefore, the broker must charge additional origination fees at the closing to earn a living and make the mortgage world go round. A broker will typically charge 1-2% in up-front origination fees if he/she is making no money on the back end from the loan. In the previous chart, if you add a 1.5% as the up-front points to the loan where the client also wants to buy down the loan to 5.5%, the total up-front points the client will have to pay will be 1.47% + 1.5% = The additional costs at the closing for a $100,000 would be $2,947 or $11,788 on a $400,000 loan. Where to price a loan? The question that mortgage brokers have to deal with is where are they going to price the loan. Assuming the broker does not use up-front origination fees, the payment to the broker will come from the back-end yield spread. The chart we have been discussing seems backward when you think of the term rebate. Usually we think of rebates as giving back to the consumer. In this case, a rebate means just the opposite. If there is a rebate, the client will receive a higher interest rate on the loan; and the mortgage broker will make more money the higher the rebate. In the chart, if the interest rate on the loan is 6.25%, the YSP would be 2.006% ( ); and the broker will make 2.006% on the entire value of the loan as compensation. FYI, some programs limit the ability to charge a YSP over a certain percentage. If the client has a $400,000 loan, the back-end compensation the lender will pay to the mortgage broker will be $8,024. This amount is in addition to any up-front origination costs charged to the client. Question: Is it better for clients to pre-pay expenses/buy down loans or buy traditional loans with no additional closing costs but where the broker is making 1-2% through the YSP? The answer depends on how long the client will keep the loan. Copyright 2006, The Wealth Preservation Institute ( 5

6 Let s just look at an example using a $400,000 loan and see how it turns out using the numbers from our chart. Let s assume the broker wanted to make 2% on the back end using the YSP. That would set the rate of 6.250% for the client s long-term interest rate. We ll compare that to the client who would have to pay 2.97% (1.5% origination fee % in points) in up-front costs at the closing to buy down the rate to 5.5% $400,000 Loan Balance Monthly Payment Annual Payment Interest Rate 5.50% (.25% below PAR) $2,271 $27, % (.5% above PAR) $2,462 $29,544 Payment Difference Each Year $2,292 Pre-payment Points (discount pts.) 1.47% $5,880 Origination Fee 1.50% $6,000 Total Up-Front Fees $11,880 (not including other typical closing costs) Number of years needed to keep the loan in place to break 5.18 Even on the pre-payment points? Remember with the above PAR loan, the client had no other nontraditional closing costs but has an annual payment of $2,292 higher each year for 30 years. With the below-par loan, the client had to pay a 1.5% origination fee which pays the broker and 1.47% in points to buy down the rate. The annual payments are less, but the client had to come out of pocket $11,880 at the closing. With this above loan, the mortgage broker will make 1.5% in with the loan where there is a 2.97% buy down/pre-payment of the rate will generate fees of $6,0000. The mortgage broker with the loan where there is a 6.25% rate with a 2.006% YSP/rebate will generate fees of $8,024. Copyright 2006, The Wealth Preservation Institute ( 6

7 The above chart does not take into account the underwriting status which would affect the ultimate interest rate your client receives on the loan. Exploring the math You ve just read the numbers. It would take 5.18 years for the client to recoup his/her closing costs of $11,880. In other words, if the client keeps the loan longer than 5.18 years, it would be better to buy down the rate than to purchase an above-par loan with no additional closing costs. Depending on what statistics you read, you ll find that the average life of a residential mortgage is less than 4.7 years. The problem with statistics is that we do not know which of our clients are going to be above or below average. Actually, if you take a close look at your clients, you can help them determine if the likelihood of them selling their home is likely in the near or distant future. If your clients are married and have good jobs, the likelihood of them trading up to a better bigger house is significant. If the same couple buys a smaller house and is thinking of having children in a few years, they will most likely want to move to a different house with more bedrooms, bathrooms, or a bigger basement. Refinancing is a completely different subject. If you and your clients think interest rates will go down in the next years, the chances of them refinancing is significant. Therefore, the discussion about current rates vs. large up-front closing costs will be different depending on the interest rate environments. Ethical dilemma MMB, CWPP and CAPP advisors have an ethical code of professional conduct to uphold and live by. The fundamentals of the code revolve around always doing what is in the client s best interest. That will be a challenge when MMB s price loans for clients. You are basically dialing in your compensation based on the back-end points you will charge. That will affect how much the client pays on a loan which could (although probably won t) be on the books for years. Understand that as a broker the money you find in the marketplace to have lent to clients is at a rate that is many times is lower than what a local bricks and mortar bank will offer. As such, an MMB should price loans at a rate with the YSP/rebate fee which is similar in price to other lenders. It is not your duty to waive fees; doing so would certainly be in the client s best interest, but every advisor needs to make a living. You need to be paid for work done on a loan; however, you do not need to jack-up rates on the back end so you can make Copyright 2006, The Wealth Preservation Institute ( 7

8 more money from a client who is ignorant or doesn t know any better. To do so would violate the code of conduct of The WPI which would result in your designation being revoked. Copyright 2006, The Wealth Preservation Institute ( 8