Why You Want The Lender to Assume Pricing Risk
In the last couple of years a movement has arisen, led by certain well meaning academics, that says negotiating a loan broker's total revenue is sufficient to get consumers a better loan. As far as they go, they are even correct - it is a better alternative than you find with the vast majority of the loan providers out there, because it removes the ability to arbitrarily boost their own compensation by kickbacks, markups, and just delivering a more expensive loan. This arrangement, which I will call compensation pricing for the purposes of this article, encourages consumer to choose the loan provider who is willing to represent that they make less money than any other. Note that this is not the same thing as actually making less money than any other loan provider.
Most consumers don't understand loan accounting. In the past I have gone over loan accounting as many as three times at and after closing with a given client because they didn't understand what were and were not costs despite me having explained it at loan sign up. I've explained it in person, then again over the phone, then to the guy's accountant, who himself had difficulty understanding the accounting on the HUD-1. For instance Impounds are not a cost, and thankfully, California now has a law that lenders can't charge for not having them. Nonetheless, for those people who do want an impound account after I explain that they are not costs but do require seed money up front, they still often want to count that seed money as a cost. They're not. Impound accounts are that property owner's own money being held to pay that property owner's property tax and homeowner's insurance, bills that that property owner would have even if there was no loan at all on the property. When the loan is paid off, the money in the impound account is promptly returned to the homeowner.
Prepaid interest is another example of money that people do not understand. It is money they would owe in any case. If they choose not to write a check for the month that they refinance, that interest charge has to be paid somehow. It is possible to roll it into the loan balance in most cases, but that is NOT "skipping a payment". You will never EVER skip a monthly payment as long as you have a loan. If you choose not to write a check, you are simply adding it to your mortgage balance.
These two items (assuming the consumer does not pay them out of pocket with a check) can easily add seven or eight thousand dollars to a $400,000 balance, but they are not costs of the loan. They are money that has to be accounted for because they are active and ongoing parts of the loan environment. The new lender is usually perfectly willing to add loaning you this money to your loan balance because they will earn interest on it, but they are in the business of loaning money for interest - they're not going to loan it to you for free. Furthermore, there are immediate cash flows back in your favor in each case. Assuming you currently have an impound account, you'll be getting that money back in the form of a check within a few weeks from the former lender, roughly offsetting the money you borrowed today. Unless your loan has a prepayment penalty, take that check and use it to pay your loan down when you get it, and you'll be roughly even on the impound account money. The same applies to prepaid interest - if you don't want to write that check, but roll it into your loan balance instead, you will then have a month where you don't make a loan payment. You emerge essentially even - except for the fact that you're now owe more money, which you'll be paying paying interest on essentially forever. It's exactly the same as if you had taken "cash out" in a refinance.
But essentially everything else is a cost of the loan itself. Appraisal, title, escrow, notary, processing, underwriting, recording, etcetera. That loan provider should know what they will cost, but most consumers have no real idea. That loan provider also knows what loans are really available, but unless that consumer is a loan broker themselves, they really don't. Various sites publish weekly averages, but that's always what the rates were, not what they are, and are highly misleading in any case. The best loans available, so called "A paper" which a minimum of 75% of all borrowers should qualify for, have their rates change every day at a minimum, and sometimes several times per day, and as of a few months ago, now vary with credit score of the applicant and loan to value ratio as well. Furthermore, all of these services that I'm aware of are based upon a national average, and even for the national lenders there are variations in the rates between the states due to some states making it more expensive to do business than others.
I cannot hit too hard on this point: That loan provider should know what they can deliver, but the consumer does not, because the informational resources available to them are nowhere near real time, and not nearly so concrete as the loan provider's ongoing experience with their lenders and third party service providers.
Compensation pricing leaves the consumer assuming pricing risk on the loan. The first implication of this is that even though you have negotiated their company revenue, they can still lowball their quotes. You've mutually agreed that they're going to make $2500 for doing this loan - but they're still competing with Larry the Loan Low-baller, and they know it. The vast majority of competitive pricers offered what looks like a cheaper loan will switch, regardless of whether it really is better. The incentives for low-balling and pretending that costs they you are going to pay do not exist, but guess what? You're still going to pay them. Quoting a shorter rate lock period than necessary to deliver the loan means that they can pretend you're going to end up with a cheaper loan, but what happens if rates rise between quote and lock?
A subsidiary weakness of compensation pricing is "What does it include?" When negotiating compensation pricing, I have to include processing because sometimes I do my own when I want something handled just so, and even when I don't, I use an in-house processor. Since I'm negotiating total company revenue, I have to include that in my negotiations. Somebody who uses strictly contract processing can exclude processor cost from negotiations in compensation pricing, because that money is going to a third party they can show a receipt for. Were any direct lenders to negotiate compensation pricing, it would have to include all their lender imposed fees such as underwriting and document generation, as well as secondary loan market premium they expect to receive from the loan (a number which would vary with developments in the financial markets as the loan progresses, by the way). Brokers usually are significantly cheaper than direct lenders, but these numbers would appear to amplify that difference far more than warranted, and is a reason you'll fly to the moon by flapping your arms before direct lenders honestly negotiate their total compensation in this manner.
This leads into another weakness of compensation pricing. The FTC did some research a while back which directly highlighted this fact, that choosing the lowest loan provider compensation does not translate into the best loan. Focusing on loan provider compensation takes your eye off the ball of the best bottom line to you, the consumer. If that loan broker is going to make $2500 for your loan, no matter what, do you think the broker is motivated to aggressively price your loan with every possible lender and find you the best possible price on that loan, or are they motivated to go with the loan they can get through underwriting most easily? It really does make a huge difference, if they take the time time to understand the niches a given lender is aiming at. More than once, by shopping the right lender I've come in with quotes that would enable me to tack on two points of compensation to my company revenue and still deliver a better loan than my competition. Not to mention I was willing to assume the pricing risk, and they weren't.
Compensation pricing also assumes that the broker or lender is honest about their revenue. Given the facts in the second through fifth paragraphs of this article, that one is worth more laughs than Robin Williams and Bill Cosby combined have gotten over the course of their entire careers.
What is the alternative to the consumer retaining pricing risk? The lender (or broker) assuming it, of course. It really doesn't take much more information. The lender indicates in writing the loan type or characteristics, the interest rate, the total cost, and whether or not there is a prepayment penalty attached, then guarantees in writing that they will pay anything above that level. Note that all of this information is necessary, and four things really isn't a lot to remember. rate and cost are always a tradeoff for any given loan type, so ignoring one to concentrate upon the other makes your shopping for a loan a complete waste of time. Making certain you're talking about the loan type you want is a real good idea unless you're willing to risk getting stuck with something else, and the presence or absence of a prepayment penalty (and for how long!) can make a huge difference. Two percent on the rate is not at all unusual, so failing to nail them down as to whether there's a prepayment penalty is a real problem. Here's a list of Questions you should ask every provider you shop before you sign up for their loan.
Furthermore, focusing on guaranteed pricing means that you're focusing on what's really important to know: How much money this loan is going to cost you over time. You're zeroing in on the bottom line to you, not extraneous and distracting information about how much someone is going to make providing it. Wal-Mart makes more per item than most of their competition, but people shop there in droves. Why? Because the bottom line is better for them, the customers. If I offer to sell you the exact same television $100 cheaper than my competition, which set are you going to buy? Do you even care if I'm going to make $50 more than the other salesperson? The situation is the same with loans.
Quote guarantees are not a panacea. It can be exceedingly difficult to enforce them right when you need the loan, so I still recommend a back up loan if you are at all unsure of that loan provider's intent to deliver the loan they promise. There are limitations upon the best of quote guarantees, as loan officers are not loan underwriters and cannot write loan commitments. The loan officer cannot promise you the loan; they can promise you the rate and cost provided the underwriter approves it, and they can go over the main guidelines with you to make certain there isn't a known reason for the loan to be rejected.
But by forcing the lender to assume pricing risk, you are far more likely to end up with a better loan out of the process, because they have to tell you about the real costs and the real rate that they have reason to believe you will qualify for. If they don't, the difference comes out of their pocket, not yours, whereas in any other pricing scheme, who do you think is going to get stuck for the difference? For this reason, I'll recommend any guarantee that forces the lender to assume pricing risk over any loan quote that does not. Even if the other quote is lower, without that pricing guarantee what evidence do you have that they intend to deliver that lower quote? There is no sufficient answer to that question. If they intend to deliver, they should be willing and able to guarantee pricing.
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