I wrote this article about yield spread premium, two years ago and it still is the number one hit article from Google Search. I met with two young buyers today, looking to buy their first home. They described themselves as "information junkies" and asked how brokers have "hidden costs".
Yield Spread Premium isn't a hidden cost; it's fully disclosed both at application and on the final HUD-1 Settlement Statement. Here's the most read article on this weblog:
There is a lot of good information about a pricing mechanism in the mortgage market called "rebate" or "yield spread premium". Mortgage brokers will often refer to this term as YSP. Bill Archambault, a former mortgage broker and Realtor from Nevada, has written a whole bunch of books aimed at consumer real estate education. He runs The Real Estate Investment Institute and teaches people how to buy homes for profit. Bill wrote an article entitled, A Consumer's Guide To Mortgage Brokers and The Evil Yield Spread Premium. Bill summarizes that the consumer should focus on rate and fees as a shopping mechanism. I suggest it to borrowers now before they commit to a loan application with me.
Another good source for understanding how to understanding the concept of yield spread premium is from Jack Guttentag, a retired professor from the Wharton School of Business at the University of Pennsylvania (in my hometown of Philadelphia) . Jack has a website called The Mortgage Professor.
I'm going to use Jack's example of points and negative points with you, the Realtor, acting as a fiduciary for your client. I have heard many Realtors explain that they don't really understand the whole "YSP thingy". I hope to make it easy to explain and simple for you, the Realtor, to check your customer's loan application disclosure documents and the estimated and final HUD-1 Settlement Statement.
Discount Points are upfront interest to the borrower . Along those lines, so are closing costs from third-party providers. This means that we figure in those costs as the true COST of credit to the consumer and measure it as an annual percentage rate (APR). There are 2-3 good arguments about why APR is an antiquated measure but I'll leave them for another article. Borrowers pay points to lower the rate. A common term is to "buy down the rate".
Did you know that mortgage brokers get money at a wholesale cost? It's how we make profit. Just like your local Nordstrom's, we buy at wholesale and sell at retail. The only difference is that we, acting as a mortgage broker have to tell the customer three times what we expect to profit on their mortgage transaction: First, within three days of an application on a good-faith estimate, at the bottom of the itemization (bottom of page 1 of the California MLDS), second, within three days of drawing loan documents (same disclosures), and finally, on the HUD-1 Settlement Statement as a paid outside of closing (POC) item.
That profit, paid by the lender to the broker is called yield spread premium or YSP. You can understand it as "negative points". if a consumer "pays points to lower the rate", why can't they "receive points to accept a higher rate". Instead of paying upfront interest in the form of a discount point, they receive upfront interest in the form of a "YSP". That receipt of upfront interest defers the mortgage broker's fee!
Let me give you a raw example. If I wish to earn a mortgage brokerage fee of 1% of the loan amount plus $495 processing fee on a $400,000 loan, here are 3 ways I can do it for a customer who wants to take advantage of YSP (or negative points). Let's assume that the third party (or HARD) costs of this loan are $4,000:
1- The customer gets a rate of 5.875% with no YSP. The customer-paid fees will be my $4,495 PLUS the $4,000 third party fees for a total of $8,495.
2- The customer gets a rate of 6.25% with 1% YSP. The customer-paid fees will be my $495 PLUS the third party $4,000 for a total of $4,495. The lender will pay me (the mortgage broker) the other $4,000 of my fee. the borrower really pays it in the form of a higher interest rate.
3- The customer gets a rate of 6.625% with a 2% YSP. The customer-paid fees are only $495! The lender pays me (the mortgage broker) my $4,495 and I credit the remaining $3505 from the YSP to the borrower for all of the third party fees. That's enough to include the title premium, "lender junk fees", appraisal, etc .
Why would a customer want to pay a higher rate if he qualifies for a lower one? The answer is in paragraph six; they actually receive negative points! Hey! What about their payment? Isn't it going to be higher? Of course it is! In the difference between option one and three , it is $250/month in extra interest or $3,000 year. They receive $8,000 upfront in negative points for that $250/month. Then, it's a matter of simple math. I ask the customer if they intend to keep this mortgage for more than 32 months (the breakeven point). If they say, "No, we'll probably refinance to remodel", then they should take the negative points and higher rate. If they say. "Yep. We expect to be in this loan until we pay it off", then I advise them to pay the third party fees and my mortgage brokerage fee upfront and take the lower rate! Jeff Belonger does a nice job of explaining in this post about the Myth of Zero Point Mortgages.
If you are used to dealing with a direct lender, correspondent lender or bank, they do not have to disclose yield spread premium to the customer because they are making the credit decision, funding the loan, and reselling it on the secondary market (Wall Street). if you want to be certain that your customer is getting a fair deal from a direct or correspondent lender (or bank) , ask a mortgage broker to furnish you with a good-faith estimate at identical rates and fees from the direct lender so you can see the "profit" the lender is making.