How Loan Providers Make Money
In an attempt to debunk some of the slanders that are floating around out there, this article is an itemization of how lenders and brokers make money on loans.
The first method is obvious: Origination or discount points charged to the consumer. This is money that the person getting the loan is paying, or someone else is paying on their behalf. One point is one percent of the final loan amount, two points is two percent, and so on and so forth. There is an actual difference between origination and discount points, but they have become almost interchangeable in their usage by many lenders and loan officers. Origination has to do with a fee charged for getting the loan done. It's not a trivial amount of work to get the loan done, and unless you're a close relative or have repeatedly saved their life, the person doing the loan is going to get paid somehow (and often, the family member or close friend gets rooked the most). If you're uncertain just how they are making money, you should ask. Discount points are theoretically a rate that the actual lender is charging in order to give you a rate better than you would otherwise get, but many brokers camouflage origination points as discount points and many banks camouflage origination points as discount points. The former makes you think the bank is making the money when it's the broker, while the latter makes the consumer feel like the lender isn't charging them origination, but that you are actually getting something most consumers quantify as real for their money (This also makes you feel like you're getting something for nothing, always a good selling point to anything).
Related to this are junk fees or markups of legitimate fees that are required to get the loan done. I do not believe I've seen a fee that some lender or another hasn't tried to mark up. If in doubt as to whether there's a markup, insist upon paying it directly. If they can't explain exactly what it was for in easy to understand words, it's probably a junk fee. Again, real fees usually run to about $3400 on a loan, although many lenders and loan officers are adept at hiding this.
The second way that lenders and loan officers make money is in rebates, also known as yield spread. This is pretty much limited to brokers, as neither traditional lenders nor packaging houses get direct rebates from lenders. Once again, rebates can be thought of as negative discount points and discount points can be thought of as a negative rebate. There should never be both discount points and a yield spread on the same loan. It is fundamentally dishonest. If there is a yield spread, you are being charged origination, not discount. Period.
The third way that lenders and loan officers make money is in the sale of the loan. This is only applicable to actual lenders, whether traditional or packaging house. Mortgage loans, particularly grouped in vaguely compatible bunches varying from $50 million on up, are among the most secure of all investments (indeed, in terms of historical risk, only US Treasury bonds are superior). Because they are very low risk, the lender makes a nice premium on them. As I'm writing this, CMO bonds trading at 5% even are basically at par, while 6% bonds are earning about a 3 percent premium. At par means the bank gets the face value of what they're selling, whereas a 3% premium means they get an extra $30 for every $1000 of bond value. For a $50 Million CMO offering, this is $1.5 Million. (There are other factors such as underlying quality, whether there is a pre-payment penalty, what tranches they may be assigned, and so on, but this is a basic article on the phenomenon.) By comparison, on a fairly good "A Paper" lender's pricing sheet (the first one I grabbed), 5% is not available and 5.25% carries a discount point and a half while carrying a premium on the secondary market of half a percent or so, so the lender is making two full percent on that loan at a minimum, and unlike a broker's yield spread, this is never disclosed to a client. Nor is there any limit as to how much this can be, but with even decent to good A paper lenders getting 2% or more, it shouldn't stretch your mind too much to find out that this number can go to 6 or even 8 percent in the subprime and negative amortization markets. 6 percent on $50 million is $3 Million dollars the lender gets for selling $50 million worth of loans - this translates to about 100 regular 3 bedroom homes here in California. $30,000 each, over and above any points and fees these people may or may not have paid, and for holding onto the loan for maybe one month. Believe me, your lenders are not hurting - and many even have the guts to badmouth brokers who may make $5000 while cutting the consumer's cost by $7500 to $10,000 and the bank still makes $20,000 per loan. (Note: these spreads and premiums used to be much larger 30 years ago when people didn't reliably refinance or move about every two years).
What brokers do is essentially play these lenders off, one against another on a professional basis, to see which one will cut the best deal on your behalf, because brokers are never captive audiences while the lenders regard you as theirs from the time you walk in the door.
Also, the point needs to be again that cost of a rate is always inverse to the rate for precisely the reasons of yield spread and bond premium. The lower the rate, the higher the cost. The higher the rate, the lower the cost. Some lenders and brokers may have better cost/rate tradeoffs than others, but there is always a trade-off.
The last method of receiving traditional income is to actually hold the note and receive the interest. This is actually rare these days. More often, what the lender will do is sell the loan itself while retaining servicing rights (for which they are paid, of course). Most often, the lender can make more money by selling the note to Wall Street - whether or not they retain servicing - than they can by holding the actuial note themselves. Keep in mind that the premium they get from sale of the note is immediate, and they can "sell the same money" several times per year, as opposed to just holding on and collecting the interest as it accrues.
How can (and should) you compare a broker's offer, where compensation is disclosed, with a bank's offer where it is not? First off, make sure that they are on the same type of loan at the same rate. My questionnaire here is a good start. Note that the last explicit question, "Will you guarantee this rate at this cost and cover the difference, if any, yourself?" should be answered in writing, and if the answer is "No," that's a red flag as to what their business practices are. They know what it's really going to take to get the loan done. They know what rates are available for locking today, right now. If it's not locked, it's not real, and they're playing games with your loan. As to prospective loan providers who won't guarantee their Good Faith Estimates, I have a retort I use with potential clients to whom somebody else has sold nonexistent pie-in-the-sky: "Well, if he's not going to guarantee you a 5.75 30 year fixed rate loan with one point, how about if I don't guarantee you a 5.5 30 year fixed with no points?" If it's not personally guaranteed in writing, chances are they are jerking you around to get you to sign up. None of the standard federal or state forms are binding in this sense; not the Good Faith Estimate, not the Mortgage Loan Disclosure Statement, not the Truth-In Lending form, and not the application form itself. Furthermore, keep in mind that for all third party items, such as title, escrow, attorney fees, appraisal, etcetera, they are able to exclude them from the precomputed costs of doing the loan, so most lenders and loan providers do. Not coincidentally, these are the biggest items in the closing costs section of your loan. Insist upon full disclosure of each item, and ask them to guarantee the total.
And once you are certain that the loans you are being told about are actually the same loan or the same type of loan, then you can make the decision as to which is better by choosing the one that actually gives you, the prospective client, the better loan.
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