Editor's note: Jack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania, is a champion of the concept of upfront mortgage brokers. He wrote this article for Bankrate.com.
What makes a mortgage broker "upfront"? Upfront mortgage brokers tell you, before you retain them, how much they are charging for their services. Other brokers don't.
Mortgage brokers work hard for their money. They don't make loans -- that's what lenders do -- but they do most of the work leading up to a loan. Among other things, mortgage brokers:
- Find prospective borrowers, to whom they quote prices and other terms.
- Counsel prospects on appropriate loan programs and find one or more lenders who offer the desired programs.
- Qualify prospects against lender requirements and take their applications.
- Have the selected lenders lock (finalize) the loan prices.
- Get properties appraised and credit scores checked.
- Send letters to verify employment and income.
- Provide legally required disclosures.
- Increasingly, use automated underwriting systems to get the borrower's application approved on the spot.
- Pull together the complete file of documents that will be handed off to the lender for final checking and funding.
While it seems perfectly evident to an outsider that mortgage brokers are service providers, they don't see themselves in that way. In their own eyes, they are loan providers, meaning merchants.
It is an important distinction. Service providers tell their clients what their fee is before any services are rendered, but merchants don't. "Wal-Mart doesn't tell you how much they make on your coat," says the broker. "Why should I tell you how much I make on your loan?"
The illogic of this -- brokers don't actually buy or sell anything -- doesn't faze the broker because logic has nothing to do with it. What matters is that brokers can make more money as loan providers who don't reveal their compensation than as service providers who do.
Brokers who are not upfront mortgage brokers make their money by adding a markup to the prices they receive from wholesale lenders.
Wholesale lenders deal solely with brokers, as distinguished from retail lenders who deal directly with borrowers. Retail lenders use their own employees to perform the functions that mortgage brokers perform for wholesale lenders. For this reason, retail prices are higher than wholesale prices. Both types of lenders deliver price sheets every morning, using fax, electronic networks or the Internet. Retail lenders deliver the price sheets to their employees; wholesale lenders deliver them to their brokers.
For example, the wholesale lender posts a price for a 30-year fixed-rate mortgage of 6 percent and zero points. The broker adds a 2-point markup, quoting 6 percent and 2 points to the borrower.
Points are an upfront charge expressed as a percent of the loan. Brokers average about 2 points on loans of $150,000, which is roughly the national average. That's worth $3,000. On larger loans, they collect fewer points, although more dollars. For example, on a $300,000 loan they might collect 1.25 points, which is worth $3,750. On loans smaller than the average, they collect more points but fewer dollars.
Obviously, 2 points is 2 points regardless of how it is earned. However, brokers find it easier to earn 2 points (or any other fee they believe they deserve in a particular case) as a markup than as a fee to the borrower.
Markups allow brokers to disguise fees
One reason for this is that many borrowers don't understand the amount of work brokers must do to get a deal done or how much they can save the borrower if they do it well. Many prospective borrowers consider 2 points excessive if they have to confront it as an upfront fee.
The second reason brokers do better with the markup system of compensation is that it permits a number of practices that brokers can use to conceal their total compensation from the borrower. These are deceitful practices that brokers rationalize on the grounds that without them they wouldn't get paid what they deserve.
One practice is to quote interest rates to borrowers that are high enough to command rebates from lenders, which are retained by the broker. This allows the broker to say "The lender is paying (all or part of) my fee".
For example, the wholesale lender who charges no points at 6 percent might offer a 1.5-point rebate on a 6.25 percent loan. The broker could then quote 6.25 percent plus a broker fee of 0.5 points to the borrower. The broker would be paid 0.5 points by the borrower, and 1.5 points by the lender.
Many borrowers find 6.25 percent at 0.5 points much more palatable than 6 percent plus 2 points. It is less money out of their pockets now, and they are paying only 0.5 points to the broker. The 1.5 points paid by the lender is referred to in the trade as a "yield spread premium." These premiums are obscured on disclosure documents, and many borrowers never find out about them -- or find out too late to do anything about it.
Another practice brokers use to increase their markup covertly is to overstate the market price at the time the terms of the loan are locked. Loan providers always warn borrowers that the prices quoted to them will change "with the market" until they are locked with the lender. The problem is that the market price on the lock day is what the loan provider says it is, which provides an opportunity for abuse.
Assume, for example, that the lender's first quote of 6.25 percent and 1.5-point rebate, on the basis of which the broker quoted 6.25 percent and 0.5 points to the borrower. A week later, when the borrower wants to lock, the lender quote is 6.25 percent with a 2-point rebate. But the broker, saying nothing, locks at the original price, increasing the markup to 2.5 points -- 0.5 points paid by the borrower plus 2 points paid by the lender. If the market had moved in the opposite direction, the broker would convey the bad news and raise the price by at least enough to maintain the original markup.
The upfront mortgage broker difference
Upfront mortgage brokers don't play these games. They fix their total compensation and pass through the wholesale prices, which they reveal to the prospective borrower. It is up to the borrower to determine the combination of interest rate and points they prefer. (If they expect to be in their house for a long time, they are usually better off paying the points for a lower interest rate). With their compensation fixed, upfront mortgage brokers have no reason to conceal lender payments to them or overstate the market price on the lock day.
I started the upfront mortgage broker movement in mid-2000 with a few mortgage brokers who had developed and practiced upfront mortgage broker principles on their own. None knew about the others, and there was no way for borrowers to distinguish them from any other brokers.
These brokers worked with me to formulate a upfront mortgage broker commitment or statement of principles, which is prominently displayed on each broker's Web site. I list them on my Web site and show their URLs and the states in which they operate. I have no financial interest in or financial arrangements with any of them.
The mortgage broker industry has not exactly stampeded to the upfront mortgage broker standard. Currently, there are 35 firms listed, with a total of 60 loan officers. Most brokers are not interested. It is very likely, however, that the industry will soon be obliged to convert to a upfront mortgage broker-type regime.
Under rules proposed by the Department of Housing and Urban Development, wholesale lenders would credit all rebates to borrowers. Borrowers would have to explicitly authorize rebates to be paid to brokers -- as if they were coming directly out of borrowers' pockets. HUD also may require brokers to declare their total compensation upfront. These rules would increase the number of de facto upfront mortgage brokers from 35 to about 30,000.
Broker trade groups are fighting these proposed rules. They argue that lenders practice the same deceits, which is true, and complain of an unequal playing field. While they don't put it this way, essentially brokers believe they should have the same rights to deceive borrowers as lenders. I don't agree with that.
I do agree with the brokers, however, that lender deceits should be forcefully addressed in the proposed new regulations. I am doing my own lobbying with HUD on how this can best be done.
Comments and questions can be left at http://www.mtgprofessor.com.