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“PSST – HEY BUDDY, WANT TO BUY A MORTGAGE?” A PRIMER FOR FINANCIAL PLANNERS Cris de la Torre, Ph. D. University of Northern Colorado Christine A. McClatchey, Ph. D. University of Northern Colorado
Arguably home ownership is one of the most important investments many consumers make. Alongside the difficult choice of selecting the home and negotiating its purchase price is a myriad of complicated decisions associated with the mortgage financing process. Unfortunately, comparing one mortgage loan to another is an extremely complex task. While information is available as required under Truth-in-Lending Act and the Real Estate Settlement Procedures Act (TILA-RESPA), it is often complex and jargon-specific. Further exasperating the problem is that some required information disclosures come late in the process, impeding consumers’ ability to use them when shopping multiple lenders. More financial planners may expect to be called upon to give advice with respect to financing a real estate purchase. This article details the disclosures a consumer can expect along with an explanation of the yield spread premium. A working knowledge of both is a necessary precursor to providing adequate counsel through the mortgage lending process.
Introduction The majority of home purchasers do not have sufficient cash to purchase a home without a mortgage loan. Although “buying a mortgage” is one of the largest purchases most consumers make, the process of comparing multiple products is not a simple act. The federal government has provided a series of regulations that attempt to supply consumers with a consistent set of disclosures, stemming primarily from the Truth-in-Lending Act (TILA) (P.L.
Planning Strategies
ABSTRACT
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90-321; 15 USC §1601) and the Real Estate Settlement Procedures Act (RESPA) (P.L. 93-522; 12 USC §2601). While these regulations have been criticized for many years, efforts to amend them have been unsuccessful.1 Storms (1992) notes most financial planners prefer to work with the asset side of a client’s balance sheet—in fact, debt reduction is a common financial goal. However, because personal home ownership is a welcomed and encouraged component of a client’s asset portfolio, it follows that a large majority of the financial planner’s clients will make use of the mortgage market. Furthermore, the “size of this liability forces (financial planners) to include mortgage management as part of the planning process, since neglecting to do so could have strong consequences on the future wealth position of (the) client” (Storms, p. 87). The purpose of this article is to summarize the knowledge base financial planners should have in order to adequately counsel their client through the mortgage lending process. To this end this article: (a) provides a brief overview of the regulatory landscape, with a specific emphasis on TILARESPA required disclosures; (b) discusses the use of the yield spread premium and how financial planners can take steps to protect clients from commonplace abusive practices; and (c) provides a checklist that summarizes the salient aspects of the mortgage financing process from the perspective of a financial planner.
The Existing Regulatory Landscape With the passage of the G.I. Bill and the increased demand for housing after World War II, the middle class was borrowing in greater numbers than ever before. Policymakers and scholars soon came to realize that because creditors calculated interest rates in many different ways, quoted lending prices bore no meaningful relation to one another making it difficult for most consumers to compare the price of credit (Peterson, 2003). In light of the politics associated with housing, Congress passed legislation that provided an increased measure of disclosure and protection, not only with regard to residential housing but with consumer transactions in general. The two pieces of legislation that provided consumers with needed standardized cost disclosures are the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA). While the TILA requires disclosure of two key terms—the finance charge and the Annual Percentage Rate, the RESPA seeks to protect consumers from unnecessarily high settlement (i.e. closing) costs by requiring the timely disclosure of a Good Faith Estimate (GFE) along with a standardized Settlement Statement (HUD-1). RESPA was later amended in 1994 when Congress passed the Home Ownership Equity Protection Act (HOEPA) to protect consumers involved in high cost loans
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from predatory lending practices. These three pieces of legislation form the kernel of protective regulation surrounding the consumer mortgage transaction.
The Truth in Lending Act
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Passed by Congress in 1968, the TILA is primarily a disclosure statute as opposed to a consumer-protection statute. It requires consumer creditors to disclose salient terms of credit transactions in uniform terminology, so that borrowers can compare the terms of credit extended by different lenders in a meaningful fashion. However the TILA provides little to no legal recourse. The TILA requires lenders to disclose four major categories of information: the finance charge, the uniform Annual Percentage Rate (APR), the amount financed, and the total of payments. The finance charge is defined as “the sum of all charges, payable directly or indirectly by the person to whom the credit is extended, and imposed directly or indirectly by the creditor as an incident to the extension of credit” (Federal Reserve and HUD, 1998). Primary examples include interest, service charges, private mortgage insurance, points and origination fees. The APR for closed-end credit is defined as the finance charge expressed as an annualized rate that mathematically equates the stream of payments made over the life of the loan to its present value. It is intended to express the cost of credit as an annual rate by showing the correlation between the finance charge and the amount financed, given the prescribed repayment terms. Both the APR and the finance charge have been extensively criticized. The finance charge and APR disclosure requirements were designed to protect consumers in lending situations from becoming unknowingly obligated to pay hidden and unreasonable charges. However, the TILA and Regulation Z provide exceptions to the broad definition of the finance charge, substantially narrowing the charges required to be disclosed. For example, voluntary insurance premiums to protect the debtor’s life or collateral may or may not be perceived to be a finance charge, depending on whether the cost is viewed from the perspective of the consumer or the creditor. Likewise, Congress excluded title insurance, appraisal, and document preparation fees from the APR, whereas the Federal Reserve Board excluded application fees.2 Even if the finance charge and the APR were to include all fees, they would still fall short of fulfilling their intended use as a comparison metric because of the manner in which they are calculated. Specifically, both disclosures assume the underlying loan runs full term (i.e. a 30-year loan lasts 30 years, a 15-year loan lasts 15 years). In reality, the APR and the finance charge may incorrectly rank loan products for borrowers that plan to be in their home only a few years, or expect to refinance in the near-term. In other
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words, a borrower who expects to move (or refinance) in 5 years may be economically better off selecting a loan with a higher stated APR as that loan may actually have a lower APR if it were computed over the borrower’s anticipated investment horizon (McClatchey & de la Torre, 2006). The likelihood that the stated APR will lead to inaccurate rankings increases as the borrower’s investment horizon declines. In addition, a one-year statute of limitations provided for violation of the TILA’s disclosure requirements further undermines its effectiveness (Fogel, 2005). Borrowers often do not realize that material terms have not been disclosed until they consult an attorney, often after the expiration of the statute of limitations. Overall both the APR and the finance charge fail in terms of their intended uses—to provide full disclosure of relevant fees, and to provide a standardized shopping tool for comparing products offered by multiple lenders. The financial planner should caution clients of the limitations and exclusions disclosure. In particular, the stated APR should not be taken as an absolute, lock-in rate of return, but rather an approximation that can change depending on a variety of factors, especially an accelerated prepayment schedule. The financial planner should discuss the client’s anticipated time horizon and assist with computing an individualized “horizon-specific” APR that could be used to shop various loan products and providers.
Real Estate Settlement Procedures Act (RESPA) The Real Estate Settlement Procedures Act (RESPA) was enacted in 1974. This legislation was passed “to insure that consumers … are provided with greater and more timely information on the nature and costs of the settlement process and are protected from unnecessarily high settlement charges caused by certain abusive practices.” Soon after, the Department of Housing and Urban Development (HUD) promulgated a set of regulations collectively known as Regulation X.3,4 Regulation X requires that lenders or mortgage brokers deliver to borrowers two documents within 3 days of application: (1) a Good Faith Estimate (GFE); and (2) a Special Information Booklet. In addition, the settlement agent must deliver to the borrower a HUD-1 Settlement Statement at closing. The HUD-1 is usually the last document reviewed and signed at closing and represents the final balance sheet or financial statement for the loan transaction. The Special Information Booklet includes: (a) a general explanation of the real estate settlement, along with the attendant typical costs; (b) an explanation and sample of the HUD-1 Settlement Statement; (c) a description and explanation of the nature and purposes of escrow accounts; (d) an explanation of the choices available to buyers in selecting persons to provide necessary services incidental to the closing; and (e) an explanation of unfair practices and unreasonable or unnecessary charges to be avoided by the ©2006, IARFC All rights of reproduction in any form reserved.
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Planning Strategies
borrower. In addition, the booklet details various RESPA protections and required disclosures, some of which may directly benefit the borrower by reducing their closing costs. For example, Section F explains that consumers have the right to shop for both a settlement agent and title company and that it is illegal for the seller to require, as a condition of the sale, title insurance to be purchased from any particular title company. HUD urges consumers to shop multiple providers of title insurance to avoid over-paying for these services.5 Likewise, Section C informs buyers that they may negotiate with the seller who will pay for the title search and various closing costs; however, this must be done at the time the purchase offer is presented to the seller. The GFE discloses, in dollar amounts, an estimate of the charges a borrower will likely incur at closing including: loan origination fee, loan discount fee, appraisal fee, cost of the credit report, inspection fee, mortgage broker fee, tax related service fee, interest at “dollars” per day, mortgage insurance premium, hazard insurance premium reserves, settlement fees, abstract or title fees, document preparation fees, attorney’s fee, title insurance premium, recording fees, city/state document recording fees, state tax, costs of the survey, and pest inspection, and room for additional non-numerated charges. These estimates are based upon what is customarily charged in the locality of the mortgaged property, and correspond to the charges that will appear in Section L of the final HUD-1 Settlement Statement. If there is both a borrower and a seller, the last document to be received is the HUD-1 Settlement Statement.6 Although the HUD-1 is generally provided at closing, the borrower can request it be provided one day in advance.7 Using the same numbering system as the GFE, the HUD-1 Settlement Statement sets out all of the final costs to be paid by the borrower, in addition to any costs that were prepaid such as the credit report, application fee, or hazard insurance. Prepaid items are shown in the margin (outside of the borrower and seller columns) and are designated P.O.C. (Paid Outside of Closing). Although the HUD-1 must conspicuously and clearly itemize all charges imposed upon the borrower in connection with the settlement, the itemization does not require an explanation of the nature or purpose of any individual cost. The financial planner’s role with respect to RESPA disclosures is two-fold. First, during the “loan shopping phase,” the financial planner should counsel the client of the inherent limitations of the GFE. Most consumers receive a preliminary GFE and APR quote to assist them in selecting a lender and specific loan product. Borrowers must understand that the GFE is only an estimate; it does not include all possible charges and hidden costs, such as settlement agent courier charges and other miscellaneous charges. In addition, the client should be informed of HUD’s Special Information Booklet. Although lenders have until 3 days after application to deliver it, much of its content is directly relevant to understanding the fees,
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required disclosures, and general lending process. This information is invaluable to any consumer in the shopping phase, and the borrower need not wait to review it until delivered by the lender.8 After a lender has been selected, the financial planner should monitor the loan process to ensure that the client receives the necessary disclosures in a timely manner. Unfortunately, RESPA does not impose liability for an inaccurate or incomplete GFE, or even failing to provide one; as a result, many borrowers never receive one. Attention should also be directed toward the borrower’s right to inspect the HUD-1 Settlement Statement 1 day prior to closing. The financial planner should counsel the client to keep the GFE so it can be compared with the final settlement costs; any discrepancies should be resolved before closing. Unfortunately, many borrowers are unaware of problems that may occur during closing, or mistakenly think that the settlement agent is representing their best interests. Furthermore, if the Special Information Booklet has not been delivered or reviewed, then the charges listed on the HUD-1 Settlement Statement are incomprehensible to the borrower—who may not realize some fees could have been avoided, shared with the seller, or negotiated at a better cost. There has been substantial discussion about lenders offering “guaranteed closing costs” – i.e., rather than charging for each fee individually, the lender quotes a single, all-encompassing price for a basket of services. Although some lenders do currently offer such products, others point to RESPA Section 8 as a major impediment, given its prohibition against referral fees, fee splitting, and unearned fees. Without legislative relief, many creditors assert they will not be willing to provide such guarantees.9
The Home Ownership and Equity Protection Act (HOEPA) In 1994 Congress further strengthened disclosure regulations when it passed the Home Ownership Equity Protection Act (HOEPA) as an amendment to the TILA. The HOEPA regulates a special class of closed-end loans that are made at higher rates or with excessive costs and fees, including prepayment penalties that discourage subsequent refinancing on more reasonable terms. These loans are not only subject to special disclosure requirements but, more critically, they are also subject to restrictions on terms commonly used by predatory lenders. While HOEPA seeks to protect homeowners from loan agreements that are likely to result in default and loss of their homes, it does not prohibit loans with high interest rates or fees, nor does it cap rates or fees. The Federal Reserve enforces the HOEPA through Regulation Z. The HOEPA provides protections for high-risk borrowers through the use of a rate trigger and a fee trigger who obtain high-cost loans . The interest rate trigger is met when the loan’s Annual Percentage Rate exceeds ©2006, IARFC All rights of reproduction in any form reserved.
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The Yield Spread Premium Problem11 When RESPA was enacted in the mid-seventies, most residential mortgages were originated, funded, and held by banks, saving and loans, and to a lesser degree, mortgage bankers. The subsequent development of the secondary mortgage market substantially changed the landscape by allowing these functions to be separated and performed by different entities. In particular, the origination function is now performed by retail mortgage brokers in many cases.12 The origination function includes finding clients, counseling them on available loan types, selecting the best lender and loan product, and gathering
Planning Strategies
the yield on a Treasury security with a comparable maturity date by more than 10% (the Federal Reserve Board may adjust this trigger down to 8% or up to 12%).10 The fee trigger is met when the sum of the loan’s points and fees payable at or before closing (including compensation to mortgage brokers, but excluding certain bona fide third party fees) exceeds the greater of either $400 (adjusted for inflation), or eight percent of the total loan amount. If one of these triggers is satisfied, the HOEPA-Regulation Z regime mandates the lender give the borrower a set of basic disclosures 3 business days before the loan is closed. These disclosures are provided in addition to regular TILA requirements and, when combined with the TILA’s 3-day right to rescission, provide the consumer with at least 6 days to reflect on the appropriateness of a particular loan (Eggert, 2002; Pyle, 2003). Additionally the HOEPA sets out, in fairly specific terms, what the loan may not contain. Among its prohibited terms are certain balloon payments, prepayment penalties, payment schedules, and increased interest rates upon default. These terms have been deemed per se impermissible because they have long been associated with predatory practices, and it is thought there is little or no legitimate reason for such terms to be included in high-cost loans. Financial planners should be aware of the conditions necessary for a borrower to come under the protection of the HOEPA. Furthermore, they should have a good working knowledge of its additional disclosures and ensure that the client is advised of them, as well as of the additional rescission time. Unfortunately the probability that a mortgage loan will fall under the auspices of the HOEPA is rather low; predatory lenders often ensure the HOEPA provisions do not apply to their loans, therefore only a very small percentage of mortgages actually exceed the HOEPA threshold. The financial planner should inform high-risk clients that many lenders proactively attempt to avoid lending under HOEPA which, at the margin, may be even more dangerous. In other words, a client that borrows at a sub-prime rate, yet is not covered by the HOEPA, may be in the very type of situation that the HOEPA attempts to protect, but without the aid of additional disclosures and protections.
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all of the necessary documentation (i.e. loan application, credit report, property appraisal, property survey, verification of employment, and verification of bank deposits). This information is processed and sent to the lender (who actually funds the loan) to review and make a final credit decision. If a borrower contracts directly with the lender, the borrower must compensate the lender for performing the origination function. In contrast, if the borrower contracts indirectly through a mortgage broker, the mortgage broker must be compensated for performing the origination function. The most common form of broker compensation is an origination fee paid by the borrower at closing (e.g. 1% of the loan amount). These fees are typically paid by the borrower at settlement and appear on the GFE and HUD-1 Settlement Statement. However, many brokers may also receive indirect compensation paid by the lender, in the form of a yield spread premium (YSP). Unfortunately, the YSP is disclosed in an obscure manner, if it is disclosed at all.
A Description of the Process Payments to mortgage brokers by lenders characterized as yield spread premiums are based on the contract interest rate and points of the loan entered into by the borrower as compared to the par or wholesale rate offered by the lender for that particular loan. For example a wholesale price sheet provided to a mortgage broker may indicate the par rate is 6%. The par rate refers to the contract interest rate the lender offers for a particular set of terms (e.g. credit rating, lock-in period, loan maturity, etc.) with no premiums or discounts. If the borrower agrees to pay a contract interest rate of 6.5%, the difference (or at least part of it) can be paid to the broker as a lump sum at the time of closing; that is, the lender would pay the broker some or all of the additional interest the lender expects to receive over the life of the loan, in present value terms. As the name “yield spread premium” implies, the larger the difference or spread between the wholesale par rate and the agreed upon contract rate, the larger the premium paid to the broker. Yield spread premiums do have legitimate uses for some borrowers. First, YSPs can act as a financing tool for cash-strapped homebuyers. Rather than paying closing costs (which include broker compensation such as origination fees), these expenditures can be “financed” over the loan’s term via a higher contract rate of interest. Specifically, the lender pays the mortgage broker’s compensation at closing through a YSP, and then recovers this cost over time from the borrower by receiving a loan with a slightly higher interest rate. Financing options and products such as “no fee, no point” loans depend on the feasibility of the YSP to compensate the loan officer for the services; in turn, the borrower does not have to pay this cost out of pocket at closing, which allows them a home purchase with less money down. While some cash-short borrowers could accomplish this on their own by ©2006, IARFC All rights of reproduction in any form reserved.
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Planning Strategies
increasing the loan amount to cover closing costs, many of these individuals are likely already at the maximum loan-to-value ratio permitted by the lender. Second, YSPs may also be a favorable financing option for borrowers that expect to refinance or move in the near future. For these individuals, the disadvantage of a slightly higher contract rate (and hence slightly higher monthly payment), is far outweighed by the sharp reduction in closing costs; obviously this benefit is greater for very short-term loans.13 The problem is that YSPs are not necessarily used to lower the borrower’s closing costs. Some brokers (or lenders) who have been fully compensated by loan origination fees and other direct payments also receive unearned additional compensation; that is, the YSP is paid in addition to the borrower-paid origination fee.14 The end result is not only a higher priced loan to the borrower, the lender also has a loan that will be refinanced sooner. Many borrowers do not consent to or even realize they are paying the YSP via a higher contract rate of interest. RESPA requires disclosure of all compensation paid to lenders and mortgage brokers as part of the settlement transaction. In other words, lenders and mortgage brokers must disclose all “direct” compensation, including loan origination fees paid by the borrower. When mortgage brokers act as a pure intermediary or use table funding they must also disclose their indirect fees (e.g. YSPs) from lenders. However, the manner in which the YSP is disclosed is obscure. While direct compensation (e.g. processing fees, origination fees, discount points, etc.) is included in the GFE and HUD-1 with the borrower’s total settlement costs, the YSP is shown in the margin and denoted P.O.C. (paid out of closing) on the GFE and HUD-1 Settlement Statement, and is not added in the borrower’s total settlement costs. This notation system is easily missed, or misunderstood, by many borrowers. To further complicate matters, RESPA does not require disclosure of fees paid in secondary market transactions. Mortgage bankers, credit unions and thrifts, as well as mortgage brokers that fund loans with their own funds or a warehouse line of credit, are not required to disclose compensation they might receive from the subsequent sale of mortgage loans in the secondary market.15 This markup is considered part of the lenders internal recordkeeping, leaving a substantial segment of the mortgage industry under no obligation to disclose YSPs at all. Not all loans with a YSP reflect abusive practices; however, the problem may be more widespread than many think. Jackson and Berry (2002) found: (a) 85 to 90% of all transactions in their study involved a YSP paid by the borrower; (b) in more than three-fourths of these cases, the loan was less than the lender’s maximum loan-to-value suggesting there was no need to finance closing costs via the YSP—as the amount borrowed could have been increased; (c) mortgage brokers made an average of $1,046 more on loans with a YSP than they did on comparable loans unaffected by these practices; and
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(d) borrowers retained 25 cents of benefit for each dollar paid in YSPs—the vast majority (about 75%) served only to increase the broker’s compensation.
Recent Cases and HUD’s Position on YSPs In 1992 HUD issued a major revision on Regulation X, the Federal Reserve’s rule that interprets RESPA. The 1992 rule did not take an explicit position on whether a YSP violated RESPA’s Section 8 prohibition on illegal kickbacks, referral fees, and unearned fees; that is, it did not state whether these payments were per se legal or illegal. Instead, the revision gave examples on how YSPs were to be denominated on the HUD disclosure forms. Given the ambiguity created by HUD’s 1992 amendment, it is not surprising that litigation arose subsequent to the rule change. In a major 2001 appellate court case referred to as Culpepper,16 two borrowers contracted with a mortgage broker to obtain a federally related mortgage loan from a lender at 7.5%. At closing, the borrowers paid the mortgage broker a fee for helping arrange and originate the loan. The borrowers were unaware that, in fact, the lender’s par rate was only 7.25%, allowing the lender to pay the broker a YSP in the amount of $1,263.61 for bringing in the loan at a higher contract interest rate. Subsequently the borrowers sued, challenging the legality of the YSP under RESPA’s prohibition against kickbacks and referral fees. The Court of Appeals ruled that a jury could reasonably find YSPs were illegal kickbacks or referral fees. Further still, the court described HUD’s subsequent 1999 Statement of Policy as “ambiguous.” The 1999 HUD Statement of Policy introduced a two-step individualized inquiry to determine whether any such payment is in fact a legal payment under Section 8 of RESPA. First, a determination must be made as to “whether goods or facilities were actually furnished or services were actually performed” by the mortgage broker. The policy statement clearly indicates a loan, by itself, is not a good or service sufficient to justify additional fees in the form of a YSP. The second inquiry must determine “whether the payments are reasonably related” to those goods or services. The reasonableness of the compensation depends on the number and types of goods and services performed and the standard charged in the locality of the mortgage property. In addition, the policy statement directed that all such fees must be clearly explained, without any code-like abbreviations. In making this two-step analysis, HUD directed that, whether paid by the borrower or the lender, the broker’s total compensation should be examined; that is, HUD’s position when it comes to receiving a YSP and direct compensation in duplication for the same services is clear:
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While mortgage brokers may receive part of their compensation from a lender, where the lender payment duplicates direct compensation paid by the borrower for goods or facilities actually furnished or services actually performed, Section 8 is violated (italics added). In light of the fact that the borrower and the lender may both contribute to some items, HUD believes that it is best to evaluate seemingly duplicative fees by analyzing total compensation under the reasonableness test described above.17
Protecting the Client from Abusive YSP Practices A primary task for the financial planner counseling a client in the mortgage market is to empower the client with knowledge of the different regulatory mandated disclosures; equally important is familiarity with the YSP process. Given potential of the YSP cost, as well as anecdotal evidence that suggests abusive practices are not isolated, it is natural to ask what the financial planner can do to minimize these risks and costs for clients. A concept—termed the Upfront Mortgage Broker™ (UMB)— espoused by Jack Guttentag, Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania and founder of GHR Systems, Inc., a mortgage technology company, lays the groundwork for addressing YSP
Planning Strategies
Overall a broker is not allowed to keep the YSP if borrower-paid direct compensation sufficiently compensates for the services. For example, if a mortgage broker quotes a customer a loan rate and direct compensation for the services and subsequently then, rates drop prior to the lock creating a YSP situation, HUD’s position would clearly indicate that Section 8 is violated if the YSP is not returned to the borrower. As the Culpepper case indicates, the court believed that HUD’s 1999 Final Rule was ambiguous. HUD apparently agreed with the court, prompting a 2001 clarification concerning, among other issues, unearned fees under § 8(b) of RESPA.18 HUD reiterated its 1999 requirement that a YSP must be exchanged for goods or services performed and that referrals or nominal, duplicative work would not meet the standard. HUD also reaffirmed the second prong of the 1999 test that included the reasonableness of the mortgage broker’s total compensation, as adjusted for the local market. HUD also discussed the need for meaningful disclosure with regard to the YSP, but did not extend the 1999 rule in any meaningful way.19 In summary the 2001 clarification only reaffirms the 1999 Final Rule and does not provide any additional protections or prohibit any explicit actions by mortgage brokers. Clearly, HUD is aware of potential YSP abuses, but has not moved to increase its regulatory oversight.20
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abuses. The foundation of his program is to ensure fair treatment via pricing transparency and the absence of conflict between broker and customer. The idea of the program is that a UMB is willing and committed to show the borrower the wholesale price sheet of interest rate quotes and discuss the fee process in advance and in writing. While the UMB is not obligated to credit the borrower with the YSP, the borrower is given full disclosure about the yield spread premium and with this knowledge can make a better informed decision. Although the UMB model has not been used or emulated by many in the mortgage industry a quick perusal of Dr. Guttentag’s website indicates a presence of UMBs across the U.S.21 Irrespective of who the client selects to work with, the financial planner should counsel clients to first ask the mortgage broker to disclose the cost of funds (i.e. the par or wholesale rate)22, and second, to transact only with mortgage brokers that agree to credit the YSP to the borrower. All payments to brokers would then be made by the borrower, from either their own funds or from the YSP credit. In other words, borrowers would knowingly control total broker compensation. Not only would this ensure disclosure of the YSP, it would also require the conscious act of allocating the amount back to the broker. While this does not mean the broker is prevented from receiving all or part of the YSP, it would require disclosure of the “added services” performed by the broker that would detail why this amount should be paid.23 For borrowers that are not cash-constrained the decision to utilize a YSP is really a financial consideration that should be determined separate from the broker’s compensation. To illustrate this, consider the sample wholesale rate sheet in Appendix A. The rate sheet depicts the contract rate / point combinations offered by the lender for 15-, 30-, 45-, and 60-day lock periods. Most consumers, and financial planners, are quite familiar with discount points – up-front fees paid by the borrower to buy down the contract rate of interest. On the wholesale rate sheet, cells with positive entries correspond to discount points. For example the hypothetical lender’s par rate (e.g. zero points) for a 30-day lock period is 5.5%. A borrower applying for a $100,000 loan, could choose to buy down the rate to 5.375% by paying the lender $625 (.00625*$100,000) in discount points at closing. The evaluation of discount points by means of break-even analysis is relatively widespread (Storms, 1992). That is, the number of months it will take to recover the up-front fee with lower monthly payments is computed and compared to the borrower’s anticipated time horizon. Obviously, the longer the anticipated time horizon the more advantageous it is for the borrower to buy down the contract interest rate. The YSP can be simply viewed as negative discount points. On the sample wholesale rate sheet, cells with negative entries correspond to YSPs. It follows that a similar type of breakeven analysis could be applied. For example, a consumer could choose to receive $1,000 from the lender up-front ©2006, IARFC All rights of reproduction in any form reserved.
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in the form of a YSP (.01*$100,000) in exchange for agreeing to pay a higher contract interest rate of 5.75%. Obviously, the shorter the borrower’s anticipated time horizon, the more advantages it would be to utilize the YSP. Overall, discount points are clearly disclosed on both the GFE and HUD-1; unfortunately disclosure of the YSP is not so transparent. The financial planner should make sure that clients demand the HUD-1 Settlement Statement as soon as possible, with the intent of examining lines in the “800” series of Section L, entitled “Items Payable in Connection with Loan” as well as paying attention to the GFE, where the YSP must also be disclosed. The decision to utilize the YSP as a financing tool should be dictated by the borrower, not the broker.
The Automobile Analogy
Planning Strategies
In many ways the mortgage industry resembles the automobile business of twenty years ago. Information about a car’s invoice price (i.e. the wholesale or par rate of interest) was difficult to find. However, with continued public disclosure of invoice prices, buyer’s guides and buyer services, the need to pay the manufacturer’s suggested retail price (MSRP) is no longer necessary. Specifically, more and more car buyers understand the alternatives available to them, and negotiate from the invoice price up, rather than from the MSRP down. It is hopeful the mortgage business will follow suit as the general public becomes more educated about the price of money. The UMB program and other brokers that follow a full disclosure practice may be the “mustard seed,” that change the way consumers buy mortgages. Some may ask why this transformation has not already taken place; that is, why hasn’t the mortgage industry evolved alongside the automobile industry? A strict analogy of mortgage buying to car buying is violated in three very important ways.24 First, the invoice price of a car is uniform throughout the country; in contrast, there is no such “one price” with regard to mortgage interest rates.25 Sensitivity to regional economic downturns contributes to the variability of rates across the nation, although the creation of the secondary market has significantly reduced these effects for conforming loans.26 Second, a car’s invoice price represents its cash price—not the price if financing is factored into the total cost. Even if wholesale rate sheets were made available to consumers, daily changes in mortgage interest rates would reduce their usefulness to serving only as an “approximation” until the interest rate is formally locked. Finally, the cash price for a vehicle is set independently from the purchaser’s ability to pay. In contrast, the price for a mortgage loan is directly dependent on the borrower’s ability to repay the loan. Quoted wholesale interest rates are adjusted to reflect borrowers’ differential credit scores and other specific underwriting criteria. While the analogy may be imperfect, it may still provide a preview to the future state of
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Journal of Personal Finance
mortgage transactions. Aided by financial planners, as more consumers understand the role of the YSP, it is likely additional disclosure will be demanded. And like sunshine, additional disclosure may have a salutary effect on the mortgage lending business by eliminating high margins created by ignorance.
Conclusions Professional car buyers make a living acting as agents in the process of purchasing automobiles for others simply because some people do not like the car-buying process. Likewise a segment of financial planners may well sell their services a la carte to individuals who do not understand the process of buying a mortgage. In light of the size and economic importance of these transactions, it may well behoove potential borrowers to hire a financial planner as a mortgage buying fee-based consultant.27 The financial planner’s role in providing such services is three-fold. First, the financial planner must have a working knowledge of various disclosures that are required under the current set of federal regulations. Second, the financial planner must understand the limitations that these disclosures represent. Of particular importance are the APR and the GFE as they are commonly used by consumers to rank and select the best loan product. Finally, the financial planner would be remiss in advising clients without fully explaining the often misunderstood concept of the YSP, and providing counsel on how to protect themselves from potential abuses. Specific questions related to each of these areas are summarized in Appendix B entitled “A Checklist for Financial Planners.” Although some may argue the peak of the refinance “boom” has passed and the importance of providing such services has declined, present demographics suggest that reverse mortgages may become a more commonplace tool for retirement and estate planning purposes. Given the obvious similarities, the concepts set forth here will help to lay the foundation for understanding reverse mortgages; undoubtedly they will become an important part of the financial planning process in the near future.
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APPENDIX A Sample Wholesale Sheet
60 Day -1.875 -1.500 -1.125 -0.625 -0.125 0.375 1.000 1.625f
“Conventional” refers to a fully amortized loan. “Conforming” refers to the lenderapplied criteria that are used to adjust the rate. For example, if the loan is a FNMA interest only first mortgage, with a loan to value of greater than 90%, the lender will require a payment of .25 points. Thus, a borrower would get the listed rate if none of the conforming adjustments apply.
a
b
FNMA = Federal National Mortgage Association (“Fannie Mae”).
c
FHLMC = Federal Home Loan Mortgage Corporation (“Freddie Mac”).
d
“15 Day” refers to the lock period.
The negative sign means that the lender will pay the borrower/broker this percentage. A positive sign indicates the amount a borrower will pay the lender to get this reduced rate.
e
f Notice that the point payment the lender will require for the lower rate increases with time. Conversely, the amount of points the lender is willing to pay as a yield spread premium decreases with time.
Planning Strategies
Rate 6.125 6.000 5.875 5.750 5.625 5.500 5.375 5.250
Conventional Conforminga FNMAb/FHLMCc 30 YR FIXED 15 Dayd 30 Day 45 Day e -2.375 -2.250 -2.000 -2.000 -1.875 -1.625 -1.625 -1.500 -1.250 -1.125 -1.000 -0.750 -0.625 -0.500 -0.250 -0.125 0.000 0.250 0.500 0.625 .0875 1.125 1.250 1.500
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APPENDIX B A Checklist for Financial Planners 5 Did the client receive estimates of the finance charge and the APR? 5 Does the client understand that the finance charge and APR fail to include all fees? 5 Does the client understand that the APR is only an estimate valid for a time horizon equal to the maturity of the loan? 5 Has the client considered the anticipated time horizon and computed a horizon-specific APR for comparison purposes? 5 Did the client receive a copy of the Good Faith Estimate (GFE) and the Special Information Booklet from the lender within three days of application? 5 Did the client read the Special Information Booklet to increase understanding of the terms and practices associated with mortgage lending and the real estate closing process? Does the client understand which fees are negotiable? 5 Does the client understand that the GFE is only an estimate of the closing costs likely to be incurred? 5 Was the client informed to retain the GFE and to request the HUD-1 one day prior to closing to identify any discrepancies? 5 Has the client been apprised whether or not the loan might be considered high risk and afforded additional protections under the HOEPA? 5 Does the client understand the concept of the yield spread premium and its similarities to discount points? 5 Does the client understand valid uses of the yield spread premium? 5 Does the client understand where and how the yield spread premium is disclosed on the HUD-1 Settlement Statement? 5 Is the client aware of the Upfront Mortgage Broker™ concept? 5 Is the client capable of navigating a wholesale rate sheet?
©2006, IARFC All rights of reproduction in any form reserved.
Volume 5, Issue 3
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References
Planning Strategies
Board of Governors of the Federal Reserve System and the Department of Housing and Urban Development (1998). Joint Report to Congress Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act. Department of Housing and Urban Development (March 1, 1999). Real Estate Settlement Procedures Act (RESPA) Statement of Policy 1999-1 Regarding Lender Payments to Mortgage Brokers; Final Rule, 64 Fed. Reg. 10080. Department of Housing and Urban Development (October 18, 2001). Real Estate Settlement Procedures Act Statement of Policy 2-1-1: Clarification of Statement of Policy 1999-1 Regarding Lender Payments to Mortgage Brokers, and Guidance concerning Unearned Fees Under Section 8(b); Final Rule, 66 Fed. Reg. 53052. Department of Housing and Urban Development (July 29, 2002). Simplifying and Improving the Process of Obtaining Mortgages to Reduce Settlement Costs to Consumers, 67 Fed. Reg. 49134. Eggert, K. (2002). Held Up in Due Course: Predatory Lending, Securitization, and the Holder in Due Course Doctrine, 35 Creighton Law Review, 503. Fogel, J. (Winter 2005). State Consumer Protection Statutes: An Alternative Approach to Solving the Problem of Predatory Mortgage Lending, 28 Seattle Univ. Law Review, 435. Jackson, H. E. & Berry, J. (January 8, 2002). Kickbacks or compensation: The case of yield spread premiums, Harvard University Working Paper. McClatchey, C. A. & de la Torre, C. (in press). Comparing fixed-rate mortgage loans via the APR: Cautions and caveats. Journal of Financial Services Professionals. Peterson, C. L. (2003). Truth, understanding, and high-cost consumer credit: The historical context of the Truth in Lending Act, 55 Florida Law Review, 807. Putney A. B. (2003). Rules, standards, and suitability: Finding the correct approach to predatory lending, 71 Fordham Law Review, 2101. Pyle, M. J. (2003). A “flip” look at predatory lending: Will the fed’s revised Regulation Z end abusive refinancing practices? 112 Yale Law Journal, 1919. Rodriguez-Dod, E. C. (2000). RESPA—Questioning its effectiveness, 24 Hamline Law Review, 68. Storms, Phillip (1992, April). Guiding your client through the mortgage maze. Journal of Financial Planning, 87-91.
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Notes In 2004 HUD Secretary Alphonso Jackson proposed a reform rule to RESPA. Due to extensive and widespread criticism, the proposed changes were tabled. Undeterred, Secretary Jackson recently announced (July 1, 2005) a set of roundtable talks focusing once again on issues such as reforming Good Faith Estimate procedures, as well as requirements for more complete disclosures of broker compensation. See Simplifying and Improving the Process of Obtaining Mortgages to Reduce Settlement Costs to Consumers, 67 Fed. Reg. 49134 (July 29, 2002) for an example of a proposed final rule that was not adopted.
1
For details concerning computation of the finance charge see Truth in Lending, Comptroller’s Handbook, 1996 at http://www.occ.treas.gov/handbook/til.pdf.
2
RESPA applies to residential real estate closings that are financed by “federally related mortgage loans.” RESPA defines a “federally related mortgage loan” as a loan secured by a mortgage on a one to four family residence, including condominiums or cooperatives, and that is either (a) made by a lender insured or regulated by the federal government; (b) made, insured, guaranteed or supplemented by an officer or agency of the federal government or connected to a housing program administered by an officer or agency of the federal government; or (c) made by a lender intending to sell it to the Federal National Mortgage Association (FNMA), the Government National Mortgage Association (GNMA), or the Federal Home Loan Mortgage Corporation (FHLMC).
3
Regulation X further expands the definition of a “federally related mortgage loan” to include (a) loans made by certain creditors; (b) loans originated by certain dealers or mortgage brokers; and (c) reverse mortgages.
4
A recent $250,000 settlement between HUD and Coldwell Banker Residential Real Estate Inc. serves as an example of how some firms may try to steer borrowers to specific title or settlement companies in exchange for monetary or non-monetary kickbacks (HUD News Release, No. 05-113, 9/1/05, http://www.hud.gov/news/).
5
See 24 C.F.R. § 3500.10(b). See also 12 U.S.C. § 2603. The HUD-1A is an optional form that may be used for refinancing and subordinate lien federally related mortgage loans, as well as for any other one-party transaction that does not involve the transfer of title to residential real property. The HUD-1 form may also be used for such transactions, by utilizing only the borrower’s side of the form. The use of either the HUD-1 or HUD-1A is not mandatory for open-end lines of credit (home equity plans), as long as the provisions of Regulation Z are followed.
6
See 24 C.F.R. § 3500.10(a). This section, entitled “Inspection one day prior to settlement upon request by the borrower,” states that “the settlement agent shall permit the borrower to inspect the HUD-1 . . . during the business day immediately proceeding settlement.” Ibid. (emphasis added.) Unfortunately, few borrowers know this right exists.
7
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The Special Information Booklet can be obtained at http://www.hud.gov/offices/hsg/sfh/;res/stcosts.pdf
8
HUD has proposed a safe harbor from RESPA § 8 as part of an overall comprehensive package. See supra note 1, p. 49151. See also Eloisa C. Rodriguez-Dod, RESPA —Questioning Its Effectiveness, 24 Hamline L. Rev. 68 (2000), for a discussion of the “safe harbor” rules proposed by HUD in 1997 that outlined a procedure that would protect mortgage brokers from accusations of violating RESPA’s Section 8.
9
The HOEPA was amended in 2001 which lowered the rate trigger to 8% from 10%. HOEPA’s present form is the result of a tightening of the restrictions that occurred at the end of 2002 after congressional banking committees held hearings regarding its effectiveness See Abraham B. Putney, Rules, Standards, and Suitability: Finding the Correct Approach to Predatory Lending, 71 Fordham L. Rev. 2101, April, 2003.
10
Lenders specialize in different types of loans to certain borrower types; a retail mortgage broker is able to shop multiple lenders for the best rate/fee combination specific to each client thus enabling the broker to perform the function more efficiently in many cases.
12
Available at http://www.brincefield.com/Article-YSP.htm. See also Real Estate Settlement Procedures Act (RESPA) Statement of Policy 1999-1 Regarding Lender Payments to Mortgage Brokers; Final Rule, 64 Fed. Reg. 10080 (March 1, 1999) for a background discussion concerning the legitimate uses of the YSP.
13
If interest rates decline during the period between the initial price quote to the borrower and the lock date and the borrower is not aware of it, the broker can keep the loan at the same quoted rate, and retain the YSP as extra income (Guttentag 10/3/01 and 4/22/02). See infra note 18 for HUD’s position concerning this scenario. Need to check this reference.
14
In these transactions, the loan originator and lender are outside of RESPA’s coverage under the secondary market exceptions found at 24 CFR 3500.5(b)(7), which states that payments to and from other loan sources following settlement are exempt from disclosure requirements and Section 8 restrictions.
15
16
See Culpepper v. Irwin Mortgage Corp., 253 F.3d 1324 (11th Cir. 2001).
RESPA statment of Policy 1999-1, Supra (as previously referenced) in note 13 above p. 10086.
17
Real Estate Settlement Procedures Act Statement of Policy 2-1-1: Clarification of Statement of Policy 1999-1 Regarding Lender Payments to Mortgage Brokers, and Guidance Concerning Unearned Fees Under Section 8(b); Final Rule, 66 Fed. Reg. 53052 (October 18, 2001).
18
Planning Strategies
At times the yield spread premium can be referred to as back funded payments, servicing release premiums, or negative points. 11
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Journal of Personal Finance
HUD flirted with the idea of requiring the YSP to be reported as a credit to the borrower so that the homebuyer could “see that the yield spread premium is reducing closing costs, and also see the extent of the reduction.” Ibid. p. 53056. However, while HUD expressed the opinion that such a technique is laudable, it did not mandate the practice.
19
“HUD also recognizes, however, that in some cases less scrupulous brokers and lenders take advantage of the complexity of the settlement transaction and use yield spread premiums as a way to enhance the profitability of mortgage transactions without offering the borrower lower up front fees. Ibid. (previously mentioned reference, see 19 above), p. 53054.
20
There are no fees associated with being a UMB; Professor Guttentag polices the program, with the assistance of borrowers. The program was set up so that it is largely self-enforcing in the sense that the client knows whether the broker has lived up to the commitment or not. To date, there have been several UMBs that were removed from the program based on client complaints. The authors of this article do not vouch for or endorse the UMB program, other than to explain its existence and purported objectives. The interested reader is urged to consult Dr. Guttentag’s website for more information. The URL address is: http://www.mtgprofessor.com/ upfront_mortgage_brokers.htm.
21
22
A partial wholesale sheet is included in Appendix A.
Jack Guttentag presents the following analogy: “In many purchase transactions, especially those involving FHA mortgages, the home 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.”
23
There is also the issue of the 3% hold-back that manufacturers give dealers as part of their compensation. At first blush, it may well appear that hold-back is directly analogous to the YSP; however, the comparison is lacking because the YSP is variable, does not always exist, and sometimes only benefits the borrower. The hold-back on the other hand is always between the dealer/manufacturer, and is fixed as a percentage. On the other hand, the YSP and the hold-back do represent less direct method of compensations that customers may not be aware of. Perhaps the better analogy would be to compare the YSP to the dealer incentives that can be shared with customers.
24
25
A variety of consumer protection and anti-trust laws prohibit differential pricing.
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In contrast, jumbo mortgage rates vary significantly within and across different regions of the country. During a regional recession, property values soften; depositories attempt to shore up their capital bases, often reducing their portfolio lending. This restriction in credit availability manifests itself as a combination of higher loan rates and stricter underwriting standards by portfolio lenders.
26
Philosophically consistent for fee-based financial planners, a natural extension of their business would be to help clients with their mortgages. Conceivably the financial planner could be employed to manage the whole process, or provide an hour of counsel at the very beginning of the transaction. Obviously much would depend on the client and the nature of the financing.
27
Planning Strategies
Contact Information: Cris de la Torre, Ph. D., Associate Professor of Finance, Kenneth W. Monfort College of Business, University of Northern Colorado, Campus Box 128 Greeley, Colorado 80639; Phone: (970) 351-1240; E-mail:
[email protected] Christine A. McClatchey, Ph. D., Associate Professor of Finance, Kenneth W. Monfort College of Business, University of Northern Colorado, Campus Box 128, Greeley, Colorado 80639; Phone: (970) 351-1248; E-mail:
[email protected]
