Debunking the Idea of "Lenders Are All The Same"

Just like Mohandas Gandhi and Genghis Khan and Attila the Hun were all human beings, lenders are all companies that make money by lending money to people who want it.



That's about the limit of the truth in that statement.



Lenders do, by and large, get their money to lend from the bond market. But not all lenders get their money from the same part of the bond market. Some get the money from low-risk tolerance folks looking for security, and willing to accept comparatively low rates. Some get the money from high risk tolerance folks looking for more return for their risk. Within each band, there are various grades and toughnesses of underwriting. A lender with tough underwriting will have a very low default rate, and practically zero losses. A lender with more relaxed underwriting will have more defaults, and higher losses, meaning they must charge higher rates of interest in order to offer the investors the same return on their money.



I have literally just finished pricing a $600,000 loan for a client with top notch credit and oodles of income (he's putting $800k down). Even A paper and with the yield curve essentially flat, I got variations of three eighths of a percent on where their par rate was. Every single one of them had significant differences in how steep the points/yield spread curve was (if you need these terms explained this is a good place). For one lender it was "offsheet pricing" below their lowest listed rate. This lender is more interested in low cost loans, and they take it for granted that folks will not be in their loans very long. This lender is appropriate for those who are likely to refinance within a few years. For another lender, it was "offsheet pricing" above their listed sheet prices. This lender specializes in low rates that cost multiple points, so they can market lower payments. For those few people who really won't sell or refinance for fifteen years, these are superior loans.



Which do you think is really better for the average client? Well, let's evaluate a 6.5 percent 30 year fixed rate loan that costs literally zero (I get paid out of yield spread, while rebating enough to the customer to cover all their costs), with a 5.875% 30 year fixed rate loan that costs $3400 plus two points. I always seem to be computing $270,000 loans here, but since this was "jumbo" pricing and a $270,000 loan is "conforming", which carries lower rates, I'll run through both.



The 6.5 percent loan is zero cost to the client. Nothing out of pocket, nothing added to the loan balance. Gross Loan Amount: $270,000. The 5.875% loan cost 1.875 points in addition to $3400 in closing costs. Gross loan amount $278,625. You have added $8625 to your mortgage balance to save yourself $98.40 per month. You theoretically are ahead after 88 months (7 years, 4 months), but not really even then.



Every so often I get a question that asks why they can't have A for the price of B. The answer is the same as the reason why you can't have a Rolls Royce for the price of a Yugo. Another funny thing about Rolls Royces is how expensive they are to maintain. A middle class person with a Rolls better plan on living in it. The funnier thing is, your friends, family and neighbors can't even see you in it, so there is no point in a "Rolls Royce" home loan except for utility, and if it's not paying for itself, then there is no utility (or negative utility, i.e. something you don't want), and therefore, money wasted.



Now, let's crank the loans through five years - longer than 95 percent plus of all borrowers keep their loans, according to federal statistics - and see which is really better for most borrowers. The 5.875% loan makes monthly payments of $1648.17. Over five years - 60 payments - they pay $98,890 and pay their balance down to $258,869. Total principal paid: $19,756. Actual progress on the loan (amount owed less than $270,000): $11,131. Interest paid: $79134, which assuming a 30 percent combined tax rate, saves you $23,740 on your taxes.



Now let's look at that 6.50 percent loan that didn't add a penny to your balance. Monthly payments of $1706.58, total over five years $102,395. Looking pretty awful, so far, right? But your total amount owed is now only $252,750. Total principal paid: $17,250. But this same number is also the actual progress! Interest paid $85,145, and assuming 30 percent combined tax rate, same as above, it gives you a tax savings of $25,543.



Now let's consider where you are after five years.



With the 5.875% loan, you saved $3505 on payments. But you also owe $6118 more, and the 6.5 percent loan saved you $1803 more on your taxes. Furthermore, if you've learned your lesson and rates are as low when you refinance or sell (6.5 percent on your next loan), it's going to cost you $397.67 per year from now on for that extra $6118 you owe! Net cost: $4416 plus nearly $400 more per year for as long as you have a home loan. Assuming that's "only" 25 years, your total cost is $14,358. I never spent so much money to save a little for a little while!



Now, let's consider that $600,000 loan in the same context. After all, the pricing really applies there (conforming rates are lower). Appraisal costs a little more, and so does title and escrow, for jumbo loans on million dollar houses. Let's say $3700 in costs. Your new 5.875% loan would be for $615,236 (disregarding rounding). Payment $3639.35, which over 5 years goes to $218,361 in payments. Crank it through 60 payments, and you've paid the loan down to $571,612. Principal paid $43,388, actual progress $28,388. Total Interest paid, $174,973, which assuming a combined 40% tax rate (higher income to qualify!) gives you a tax savings of $69,989.



At 6.50 percent, the payment on a $600,000 loan is $3792.40. Times 60 payments is $227,544. Crank the loan through those 60 payments, and you've paid the loan down to $561,666. Principal paid and actual progress made: $38,344. Total interest paid $189,209, which at the same combined 40% rate is a tax savings of $75,684.



With the 5.875% loan, you saved $9183 in payments. Yay! However, you owe $9946 more, paid $5695 more in taxes, and on your next loan, assuming it's at 6.5 percent, you pay $646.49 per year in additional interest. Total cost is $6458 plus $646 per year for as long as you have a home loan, which assuming that's 25 years equates to a total of $22,620!



Which of these two loans and lenders is better for you? Well, if you're going to stay 15 years or more and never refinance, the lender who wants to give you the 5.875% loan. That rate wasn't even available from the 6.5 percent lender. On the other hand, if you're like the vast majority of the population that refinances or sells within five years (for whatever reason) you really want the 6.5 percent loan whether you knew it before now or not, which also was not available from the 5.875 percent lender.



The billboards advertising rates aren't going to tell you cost, of course. They're trying to lure clients who don't know any better, and often they're playing games with the loan type as well. But when the rate spread between the rate their selling and APR is over 3 tenths of a percent, you know they're building a blortload of costs into it. Keep in mind that the examples I used were almost two full points, and they were each only about a 0.25% spread between rate and APR. You are never going to recover those costs in the time before you refinance. The lender who offers you 6.5 percent for zero cost is probably offering you a better loan.



Now, there were lenders targeting the markets between these two lenders, some that overlapped the whole market, and even another lender specializing in rates even lower and with higher pricing. Keep in mind that this article was limited to A paper 30 year fixed rate loans, which are limited in what they can possibly accept by Fannie Mae and Freddie Mac rules. Once you get out of the A paper market and especially down into sub-prime lenders, the diversity between offerings really multiplies, as the differences they are permitted in target market cover all parts of the spectrum. Some wholesalers walk into my office with the words, "Got any ugly sub-prime today?" Other sub-prime wholesalers ask me about "people that could be A paper but are willing to accept a prepayment penalty to get a lower rate" (I don't use those much). Some want short term borrowers, and their niche is the 2/28. Some want the thirty year fixed with a prepayment penalty. The ones who ask me about negative amortization loans, I throw out of my office but they're selling them somewhere. A lot of somewheres, judging from the evidence that they were 40 percent of purchase money loans here locally last year.



So lenders are not all the same. Indeed, every single one of them is different, and you need to shop enough different ones to find the program that's right for you, and ask lots of questions every time. Just asking about rate is not going to make you happy, as I hope I have just demonstrated. If you walk into their office, they're not going to tell you that you're not the client they're really looking for unless they just don't have any loans at all that you qualify for (and if you're in this category, do not blindly accept any recommendations they make. Most places, they're sending you to the place that pays the most for the referral, not the lowest cost provider).



Caveat Emptor.