Mortgage Markets and Providers and Yield Spread Explained

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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, loan type, and rate, as well as any of several other reasons. The yield spread is based upon the rate of the loan, the type of the loan, and other factors as well

Yield Spread is explicitly associated with the premium (amount over face value) that the actual lender will receive when they sell the loan. I find it entirely and intentionally misleading that the government now requires brokers to treat yield spread as a cost and added to other costs of the loan while not requiring that direct lenders disclose secondary market premium at all. The new 2010 Good Faith Estimate adds Yield Spread as a cost when under the new rules it is an offset, lowering the cost of the loan to the consumer. This has the effect of making broker originated loans appear more expensive than they are, while allowing direct lender loans to continue to hide this method in which they get compensated on basically every loan.

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 secondary market pays a premium 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. The new rules make this more difficult, but it is still happening, mostly because consumers aren't very careful. ALWAYS be careful about pre-payment penalties; they are an excellent way for lenders to sock you with thousands to tens of thousands of dollars in extra revenue that will end up coming out of your wallet.

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 for a full documentation loan, although there are caveats. Despite what you read in Internet pop-ups, according to National Mortgage Reporting a 620 credit score is 100 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. Also, it until recently it didn't matter if you were King Midas who had never failed to pay a bill immediately in full or someone who barely staggered over the line into qualification by the computer models put out by Fannie Mae and Freddie Mac. That has now changed with risk based pricing, such that credit score and equity picture can cause you to be assessed a differential, but the differential is a lot better than going sub-prime or Alt A. There is nothing better than A paper.

The next market 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. A minus is still a program associated with Fannie and Freddie for the "almost but not quite" people, although the window of qualification has become a lot narrower of late.

Then comes the so-called Alt A, which are typically loans for fairly unusual circumstances. At this update, Alt A really isn't available due to Wall Street being more nervous than a cat at a rocking chair convention, but I'm going to leave the rest of what I originally wrote untouched because it will come back: 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. Once upon a time, I saw ads for these abominations every day all over the internet. If anybody quotes you a mortgage rate below 3%, or a payment that seems too low to be true, I will bet you millions to milliamps they are trying to sell you one of these abominations. There are still loan providers out there that do nothing but these - they're easy to sell to unsuspecting victims because the minimum payment is so small, and most people shop for a home loan based upon payment. 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. Fortunately, the Negative Amortization loan has now had regulatory controls placed on it, and lenders have figured out that these loans aren't as good for their bottom line as they thought, due to a high default rate that was as predictable as falling objects hitting something.

(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. As I just said, it doesn't happen much any more, but if the first thing they talked about was a Negative Amortization 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 Amortization 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 despite him meeting all of the written loan guidelines.)

The final niche that comes from regular lenders is called sub-prime. Until recently, in the world of sub prime lending you could do a lot of things that higher rungs on the ladder will not allow you to do. As in A minus or Alt A, 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 didn't have a whole lot of choice. That has now changed. Unless you've got a very high down payment or amount of equity, subprime is being about as strict as A paper with qualification standards. However, if you don't qualify for a better market, this is typically the only way you'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. When I first wrote this, it was to the point now where if someone said they did sub prime, that usually meant Alt A and A minus as well - it's just a matter of where on the spectrum a given client sat. Nowadays, what that same provider is looking for is an A paper borrower who doesn't realize they are A paper, or whom they can make think is not an A paper prospect.

The final niche is Hard Money. These are not typical lenders, in fact, they have almost nothing in common with traditional lenders. They are agents for individual investors, sometimes even loaning you their own personal money. 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 would ever go, and all of the ones I'm aware of now have an absolute limit of 65%. Lenders in markets higher up the chain are in the business of making loans, and are 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 immediately and 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 (in fact, some lenders market their services to real estate agents and brokers based upon this practice - people who are true loan officers learn that this is not a good idea), 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 or correspondent. 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. Packaging houses are lending their own money - they are not brokers. The difference is that a traditional lender is at least set up for long term servicing - the packaging house is not. Some sell immediately, some wait for one payment (better price in the secondary market), some wait three payments, as this gets them an even better price when they sell the loan. This is nothing to fear. 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 - there is no legal impediment. They just don't do it. 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. Correspondents are a cross between brokers and packaging houses. They've got multiple providers like brokers - but the company also has a line of credit they use to fund your loan so they receive the secondary market premium rather than merely whatever yield spread there may be. They're still putting your loan through a particular lender's underwriting and funding program, but they fact that they initially fund your loan themselves allows them to act more like a direct lender.

The first reason for this is that 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. A traditional lender or packaging house puts you in the program they have that they feel is the best fit - they won't go outside the company. A broker may shop fifty lenders or more to find the one program at the one lender that fits you best. Second, 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. As a broker, I am never held captive by any single lender, and they know it, and they know I know it, where once a member of the public walks into their office, they consider you "captive" business, whereas at any point in the process, I can take my paperwork back from the lender and take you to someone else. Used to be, I usually didn't even need you to fill out anything new. That has now changed with the new Home Valuation Code of Conduct which means appraisals are no longer portable (What? You thought it was for consumers?).

Still, I do have the option of moving the loan, so they give me better pricing than they give you, and they don't play games because I've got more business every week that they want, whereas they're not going to see you again for a couple years, if ever. The upshot is: every week when I do the family shopping, I hit three or four supermarkets all competing for my business within a mile and a half from my home. Because of this competition, I can save pretty good money buying the things that each market has good sales on, and if the quality at one market isn't so hot on some sale merchandise, I will get a pretty good price at one of the others. Mortgage brokers work on the same principle. I do the running around and quality check for you, and because this is what I do for a living, I can spot the bad stuff a lot easier than you can. When I do my grocery shopping, I always make a point of checking what the banks in the supermarkets are offering on 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

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About this Entry

This page contains a single entry by Dan Melson published on May 11, 2013 7:00 AM.

The Escrow Process and Reasons for Falling Out was the previous entry in this blog.

How to Effectively Shop for a Buyer's Agent is the next entry in this blog.

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