Yield spread premiums can bite you
Buying or refinancing a home? Watch out that the loan isn't more expensive than it looks.
NEW YORK (CNNMoney.com) -- The yield spread premium (YSP) is a mystery to most home buyers, but it would pay them to get more familiar with this little understood feature of the mortgage business.
It's the basis for the fee a broker gets for selling a loan above the par rate, or the lowest interest rate a borrower qualifies for. It's a standard industry practice, but it can also be an incentive for abuse.
Say a couple buys a new house and a broker finds them the lowest wholesale rate available of 6.5 percent for a 30-year fixed mortgage. The broker needs to make money on the deal, so he offers them a loan at say, 6.75 percent. The lender then pays the mortgage broker a percentage of the total loan based on the quarter point yield spread premium.
Even though they paid an extra quarter point, the couple probably got a better deal than they could have found on their own. Brokers can also guide consumers through the maze of confusing paperwork, including filling out loan applications.
That's why, according to David Berenbaum, spokesman for the National Community Reinvestment Coalition (NCRC), brokers originate up to 70 percent of all mortgages.
But the larger the yield spread, the more a broker earns, and that can tempt them to steer borrowers to higher interest loans.
After coming up with a down payment, it can be difficult for first-time home buyers to cover closing costs that can hit five figures: the title search and insurance, legal fees, processing costs, etc.
A broker offers a "no-closing costs loan," tacking the fees onto the mortgage and raising the YSP.
Allen Hardester, a Columbia, Maryland-based mortgage brokering consultant, said, "Brokers jack up the rate and the expanded YSP is used to subsidize the closing costs. Borrowers wind up paying more every month."
If borrowers hold the loan longer than three years, they end up paying a lot more than they saved initially. But there's nothing wrong with that if they decided it was a better idea to pay more later to save during the hardest first year of ownership.
Some buyers even save money overall. If they're planning to live in the house four years or less, what they save on closing costs will not be offset by years of higher payments. The same thing happens if they plan to refinance within four years.
The big money for unscrupulous brokers, however, lies in steering borrowers into higher cost loans. A prime, fixed-rate loan at par may earn a broker a fee of one percent or less, but a hybrid adjustable rate mortgage (ARM) can pay four percent or more.
The Center for Responsible Lending (CRL) has said that inflated YSPs are included in 85 to 90 percent of all subprime mortgage loans.
Borrowers of hybrid ARMs, nicknamed "exploding" or "toxic" ARMs, often get stuck with prepayment penalties that penalize a borrower for paying off a loan early -- which can run into the equivalent of six months of mortgage payments. They guarantee lenders will get back their initial outlay over time and lock consumers into high-priced loans.
According to Michael Calhoun of the CRL, brokers may only receive an okay from lenders for expanded YSPs if they steer borrowers into prepayment penalties. The lenders don't want to pay the brokers a big fee if the borrower is not locked into the loan.
Berenbaum told a recent Senate subcommittee that brokers keep informed of the current YSPs available for themselves, not their customers, and that borrowers with little or no expertise in the field will accept their recommendations most of the time.
"Unfortunately, NCRC has documented through a nationwide testing project that too many brokers engage in steering and discriminatory practices," he said.
Borrowers can avoid YSP abuse by carefully going over any offer they get and comparing annual percentage rates.
APRs take into account all the one-time fees involved and provide a reasonably accurate picture of costs over the lifetime of a loan. They may be only listed in fine print but they will be disclosed in ads and - by law - must be disclosed before the loan can be finalized.
Beware of unsolicited offers, especially ones that purport to free up a lot of cash. The great majority of mortgage brokers are fully trustworthy but borrowers still have to protect themselves against the ones that aren't.
"At the very least, always get references," said Neil Garfinkel, a real estate attorney with Abrams Garfinkel Margolis Bergson in New York. Ideally deal with brokers who have been recommended by someone you trust.
If you feel you need objective advice, hire a real estate attorney. They can protect their clients from making serious mistakes. Their fees run from about $750 to $1,000, but you get a lot for that.
"If I'm going to manage the process," said Garfinkel, "I'm going to manage the process. I'll make sure the title company isn't overcharging. I'll go over the loan paperwork."
Refinancings are often simple enough, however, so home owners can handle the work themselves. Garfinkel advises to go on the net and "Educate yourself. Don't assume that you know everything."
And, if the deal sounds too good to be true; it probably is. Although the majority of mortgage brokers are responsible, valuable assets for home buyers, they have no fiduciary responsibility to do their best by clients. Bad actors among them have no qualms about taking advantage of borrowers.