Mortgage Markets and Providers

This post was actually ready and schedule for tomorrow night, but with the mighty Instapundit actually blogging on the subject, and David Bernstein of The Volokh Conspiracy and Bill Quick of Daily Pundit I thought I'd strike while the iron is lukewarm and reschedule tonight's post for tomorrow! I also am working on an article analysing the Negative Amortization loan in depth which should be posted withing a couple weeks. The relevant information on Negative Amortization loans is several paragraphs down in the section on Alt A loans. I'll also redact some personal marketing information from a letter I've been sending out for about three months now and post it later today.





There are actually several distinct marketplaces consumers can obtain their funds from, and several types of providers. John the wealthy highly salaried person with great credit and a substantial down payment should not and usually does not obtain his mortgage from the same funds providers as his twin brother Jim, the self-employed, always-broke person with terrible credit and no down payment. They may deal with the same employee at the same business, but the funds and parameters for using those funds, are entirely different.



In order to make sense later on, I've first got to acquaint you with two concepts: yield spread and pre-payment penalty. The yield spread is what then lender pays the person or company who does the paperwork for your loan in order to give them an incentive to choose that lender, as well as any of several other reasons. The yield spread is based upon the rate of the loan, the type of the loan, etcetera



Prepayment penalty is a penalty you agree to pay if you sell your home or refinance before a certain period of time has passed. Industry standard is six months interest, with some lenders making this 80 percent of six months interest. Usually (not always) they will let you pay a certain amount over the normal, agreed upon principal per year without triggering the penalty, but if you sell or refinance out of their loan, the penalty is always triggered for the duration of the penalty. Some lenders will actually phase it out in stages, although this is not common.



Lest it be not plain to you, a prepayment penalty is a thing to avoid if you reasonably can. Let's say you get transferred and need to sell the house in six months, and that you have a $200,000 loan at 6%. That's six thousand dollars less that you will receive from the sale of your home, not to mention that the average person refinances every two years, which is typically the shortest pre-payment penalty. If you need to refinance within two years, that's six thousand dollars of your equity gone for no good purpose. Mind you, if you need the loan, and it gets you the loan, so be it. It's still a thing to avoid.



The top of the food chain from the point of view of consumers are the so-called A paper lenders. This market is controlled by the two federally chartered giants, Fannie Mae and Freddie Mac. Lenders who participate in these markets lend in full accordance with Fannie Mae and Freddie Mac rules, because they want to be able to sell the loan to them. In many cases, they actually do sell them seamlessly by retaining the servicing rights, and the consumer never knows they have done it. In others, they retain the loans entire, and in still others, they sell them off entire. They do this for many reasons, but mostly to raise cash so they can do more loans. In any case, the only difference it should make to you, the consumer, is where to address the check and who to make it out to. Unlike the other markets, if the lender pays a yield spread in this market it does not automatically mean that there will be a pre-payment penalty. Although they will pay a higher yield spread if the loan officer sticks the client with a pre-payment penalty (and the longer the prepayment penalty is, the more they will pay). WARNING! Many loan officers will not tell you about it unless asked ("Why bring up a reason not to choose your loan?" is a direct quote I've heard any number of times) and some will flat out lie even if you ask. This is not ethical, but they know they can almost certainly get away with it. There really is no reason why an A paper loan should have a prepayment penalty, except that a loan officer wanted to get paid more.



It is not difficult to qualify for an A paper loan. As long as you're not taking equity out of the home, they can go through with credit scores as low as 620 (full documentation) or 660 (stated income), although there are caveats. Despite what you read in Internet pop-ups, according to National Mortgage Reporting a 660 credit score is more than forty points below the national average. So even someone with modestly below average credit can still qualify for an A paper loan. There are minimum equity requirements, however. And it doesn't matter if you are King Midas who has never failed to pay a bill immediately in full or someone who barely staggers over the line into qualification by the computer models put out by Fannie Mae and Freddie Mac. This is it. The top. You all have the exact same rate choices. There is nothing better.



The next niche below A paper is called A minus. The rates are a little bit higher, and there are prepayment penalties anytime the lender pays a yield spread. Then comes the so-called Alt A, which are typically loans for fairly unusual circumstances. The credit scores here go down to about 580, although there is less standardization. The worst, most dangerous, absolutely awful loan in the world comes from the "Alt A" world. There are all kinds of friendly sounding names for it, like "Option ARM", "pick a pay", and such things, but they are all negative amortization loans at their heart - you end up owing more than you borrow. They sound benign: "pick your monthly payment!" But in fact most people choose the minimum monthly payment which capitalizes and then amortizes more money into your loan every month. Every single one I've ever heard about carries a prepayment penalty. I see adds for these abominations every day all over the internet. If anybody quotes you a mortgage rate below 3%, I will bet you millions to milliamps they are trying to sell you one of these (despite the fact that there are other loans out there below 3% right now). There seriously are providers that do nothing but these - they're easy to sell to unsuspecting victims because the minimum payment is so small. There really isn't space here to go over everything that's wrong with them (or where they may be appropriate), but except in certain special circumstances, RUN AWAY! And do not do business with that person! They have just proven themselves unworthy of your business.



(Every so often, a representative from a new lender walks into my office. I'm always glad to talk to them so long as they answer my questions in a straightforward way, but I have one inflexible rule. If the first thing they talk about is a Negative Am loan - no matter the happy sounding name they call it by, I throw them out and do not allow them to return. I think it indicative of the state of things in the Negative Am world that the one time I had a client who would actually benefit from this thing, and I took the time to tell him exactly where all of the traps I knew about were, give him strategies to turn it to maximum benefit, and he agreed that he wanted to do it - not one of the five companies I tried would actually approve the loan.)



The final niche that comes from regular lenders is called sub prime. And in the world of sub prime lending you can do a lot of things that higher rungs on the ladder will not allow you to do. As in A minus, anytime the lender pays a yield spread there will be a pre-payment penalty, and I think I've run across exactly one sub prime loan that didn't have a prepayment penalty in my whole time as a loan officer. However, the people who subsidize sub prime lenders just don't have a whole lot of choice. This is typically the only way they're actually getting a home loan, be it because of low credit, low equity, or what have you. The rates are high, but it's that or nothing. Sub prime loans are very lucrative - the average lender or broker specializing in them usually makes about 5 points - 5 percent of the loan amount - on each and every loan. I've had people thank me so profusely I was almost embarrassed when I got them a loan on something more closely resembling a typical margin from higher niches. The lines between A minus, Alt A, and sub prime are blurring more and more as time goes on. It is to the point now where if someone says they do sub prime, that usually means Alt A and A minus as well - it's just a matter of where on the spectrum a given client sits.



The final niche is Hard Money. These are not typical lenders as all. They are agents for individual investors, sometimes even carrying the loan themselves in their own person. The rates for this start an absolute rock bottom of about 13 percent, and go up from there. Typically there will be a front-end charge of about 5 percent of the loan amount, and a prepayment penalty of about 7%. These are loans for people with sub 500 credit scores, people with homes that have been damaged in some way and must make repairs before a regular lender will touch the property, and so on and so forth. The equity requirements are large - 75 percent of the value of the home based upon a conservative appraisal is about the highest a hard money lender will go, and most are less. Everybody until this point is in the business of making loans, and is likely to cut you as much slack as practical if you have some difficulty making payments, as they are not in the business of foreclosures. A hard money lender has no such constraint. They will foreclose on your home without a second thought. One way or another, they will get their money back and then some. WARNING! It is common practice on the part of hard money lenders to have you sign the Note and Deed of Trust "conditional" upon them finding an investor. The person signing the documents thinks the loan is done, and that their situation (usually a time critical one) is resolved, and everything is all roses now, but it isn't. They may still want you to pay for multiple appraisals, jump through multitudinous hoops, and still not give you the loan in the end. This is just their way of binding you to them so that you don't or can't go elsewhere. Not that this is completely unknown in the higher niches, but it's not common, as it is here.



There are three main types of places to go to get a loan. The first is a regular lender. The second is what I call a "packaging house", although in practical terms it is very similar to a regular lender. The third is a broker. Each has their advantages and disadvantages.



A regular lender is what you think of when you think of a bank. Most of the big names are regular lenders. They typically have their own offices, often mingled with other banking functions. They have their own funds, wherever they've gotten them from, and they have executives and such that put together their own loan programs, complete with criteria for approving or not approving a given loan. These people do loans with at least the possibility of keeping them in mind, and some do keep every loan they do, while others sell almost every loan. The good news is that they'll typically be slightly more willing to make exceptions around the edges (whether or not the loan is a good one for you!). The bad news, from the consumer point of view, is that they consider you a captive from the moment you walk in the door. Even if they know of another lender with better pricing or a program that suits your needs better, they're still going to keep you "in-house". And their loan pricing is such that it's going to pay for all of the salaries and benefits for all of the people in the office, and the beautiful office itself and all of its contents.



A "packaging house" is like a regular lender except that they do their loans with the explicit intention of selling off every single one, either immediately or a few months down the line. Practical difference to consumer: there's a 100% chance you're going to end up making payments to someone else. In other words, no big deal. The original lender recently sold my own home loan. The only difference is that now I write the check to company B instead of company A, and mail it to place X instead of place Y. California has stronger consumer mortgage protection laws than the federal government, but there are laws in place nationwide for the consumer's protection that avoid payments being unjustly marked late because your mortgage was sold.



A broker is not lending their own money, but is being paid instead to put the loan together and get it to the point where it is funded, at which point they are out of the picture. A packaging house could, in theory, decide to keep a particular loan. A broker doesn't have this option - it's not their money being loaned, but instead that of a regular lender or a packaging house. On the down side, a broker has somewhat less leverage to get underwriters to make exceptions to the rules (although the difference is academic for those outside this narrow range). There is also a lot of variation on quality. You'll find the very best loan officers in the country working as loan brokers - and the very worst, as well. On the up side, a broker always has at least the ability to get you a lower price than the other alternatives, although they may not have the willingness. First, a good broker shops many different lenders to find the program that's priced best for you. This is less important but still very noticeable at the A paper level (A paper had pretty standardized rules) then it is for borrowers whose situations (either through credit, or through needing to do something A paper doesn't support) need to go to markets lower down on the totem pole. On the other hand, I (as a broker) get better pricing from the lenders, either regular or packaging house, than their own loan officers. Why? Partially because they're not paying my support expenses - office rent, furnishings, support staff salaries, etcetera. Mostly because it's my customer, and I can and will take my customer elsewhere if they don't give me the best possible deal. Every week when I do the family shopping, I see the banks in the local supermarkets offering their mortgage deals, and I always smile because I'm always getting somebody a better price on the same loan from that same lender.



Caveat Emptor.

UPDATE: This article has been updated here