Shop Loans By The Bottom Line To You, Not By What the Provider Makes

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When it comes to mortgage loans, people get distracted by the darnedest things.

Let's look at Wal-Mart. You think they got to be the largest retailer in the world by making less money than their competition? I assure you that is not the case. In fact, they're legendary in manufacturing circles for using their size as an inducement to get the lowest possible price out of their suppliers. With that leverage - the fact that whether or not Wal-Mart stocks your item will be a significant predictor of your success manufacturing consumer goods - they can get outrageously low prices out of their suppliers. To this, they add all of the economies of scale and function consolidation that they can possibly come up with, to the point where Wal-Mart makes more on the same item than almost any other retailer, let alone the mom and pop store that everyone complains Wal-Mart has driven out of business. How the heck do you think they can afford to build dozens if not hundreds of new "Super Centers" worldwide every year?

Their main attractiveness to consumers is one thing. Price. They deliver whatever it is, from breakfast cereal to makeup to cell phones to automotive supplies at the lowest final price to the consumer. They've also got a huge selection of merchandise so you've only got to make one stop (thereby saving on gas, if you don't count the three gallons you waste getting in and out of the parking lot), but that's not why most consumers go there. They go for price. I may hate the thought of going to stores that are even in the physical vicinity of a Wal-Mart, but you've got to give them respect for what they accomplish.

People don't shop Wal-Mart because Wal-Mart doesn't make anything on the transaction. If that were the case, we'd all be shopping government stores and paying much higher prices. No, people shop Wal-Mart because the total cost, aka purchase price, is lower there even thought they may be making more money per transaction than the Mom and Pop store that used to be a couple blocks over. Lest anyone not understand, this is a good and rational thing, not just for Wal-Mart but (as far as it goes) for society as well.

The same principle applies to loans. Shop loans by the lowest total cost of money . To know what that is, or even make a reasonable estimate, you've got to have some idea how long you intend to keep the loan. There is always a trade-off between rate and cost, because lenders have to work with the secondary markets, and that's the way the secondary markets are built. Know for a fact you're going to sell the property in two years? Then look at the costs of that loan over a two year period. In such a case, it probably doesn't make sense to choose anything with a fixed period longer than three years, and lowering the closing costs is likely to be more important than getting a lower rate, even if the payment is lower on a lower rate. That's pretty much a textbook case example of higher rate being better because it's got a lower closing cost.

If you're certain that you're going to stay in this property forever, and never ever refinance again, a thirty year fixed rate loan where you spend several discount points buying the rate down will verifiably save you money - if you're right. If you're wrong, and six months from now you're looking to sell and move to the French Riviera (or simply refinance because you need cash out), all that money you spent on points and closing costs was essentially wasted. You're not going to get it back - it's a sunk cost, used to pay the people who do all the work to make a loan happen, and to pay the rich folks who work the secondary mortgage market to give you a lower rate than you could have gotten otherwise. It's not their fault you chose to let them off the hook from that contract you negotiated. You're essentially betting a lot of money upfront that future events will happen the way you believe they will, and if you're right, you reap quite a reward. However, most folks lose this bet, which is why the (rarely followed) admonishment not to pay points for a loan gets repeated so often. That's also why people hedge their bets most of the time, by choosing an alternative that costs less, and therefore risks less, while covering a lot of future possibilities in a decent manner, if not quite perfectly.

All of this is good information to have. But there is one piece of information required of brokers but not direct lenders that distracts consumers from what is really important: How much they're making for this loan. I think it's good information to have out there providing the consumer knows enough not to give it more weight than it deserves. And it really isn't important information, because it does not impact the bottom line to you, the consumer. It's really no more important than knowing where the airplane for your flight just flew in from. The point is that it's going to cost you X number of dollars (and a known amount of time) to get on that plane to where you're going, just like the important thing for consumers about their mortgage loans is that it's going to cost them $X total to get the loan done, and they're going to have an interest rate of Y% that they're going to have to pay for as long as they keep that loan. But if it's important for brokers to disclose how much they're going to make, why isn't the equivalent disclosure required of direct lenders?

The Federal Trade Commission prepared a report, The Effect of Mortgage Broker Compensation Disclosures on Consumers and Competition: A Controlled Experiment. The upshot? Consumers will choose the loan where the company providing it makes less money, or, even more strongly, choose the loan where the company's compensation isn't disclosed at all. I think it's reasonable information for someone to want to know, but if it's important to know the information when you're dealing with a broker, and the government therefore mandates such disclosure, then why isn't it required for direct lenders? (The answer is politics, to put brokers at even more of a psychological disadvantage as far as the average person is concerned. Lenders make a lot more money than brokers, so they have a lot more money to bribe politicians contribute to campaigns). To quote from the report:

If consumers notice and read the compensation disclosure, the resulting consumer confusion and mistaken loan choices will lead a significant proportion of borrowers to pay more for their loans than they would otherwise. The bias against mortgage brokers will put brokers at a competitive disadvantage relative to direct lenders and possibly lead to less competition and higher costs for all mortgage customers.

Focusing upon what the provider makes actually hurts you. If you just focus upon how much the loan officer makes, there's no incentive for them to shop around looking for a better loan. As I've written before, if I can find a better lender for that loan, I can both make more money and offer a better loan. But if you're just going to shop by how much I make, there's no incentive to do that. I make my $X, regardless of whether you get a 30 year fixed at 5% without a prepayment penalty or a 2/28 at 8% with a three year prepayment penalty. There usually isn't that much difference, but the principle is the same. You want your loan person motivated to find you a better loan, which shopping only by how much someone makes frustrates. And if you choose a loan at a higher rate of interest and higher cost just because the company offering it is not legally required to disclose what they make, it doesn't take a genius to figure out that you're doing nothing except hurting yourself. It's the equivalent of passing up the store with the lowest price because the law requires that store (but not their competition) to hang a big sticker on it that says, "The store makes $12.98 if you buy this toaster oven." Me, I like it when people make money from my custom, especially when the bottom line cost is as good or better. It means they're motivated to work hard and do a good job so they get my business again next time I'm in the market. The principal is the same whether it's a big box retailer, a mechanic shop, or a real estate loan.

Finally, at loan sign up, the prospective lender can lie, just as much as any other item, even on the new good faith estimate. The government may tell you they can't lie on the form, but the form itself is effectively lying because what it really means is that it can't change without being redisclosed with a new Good Faith Estimate. Indeed, the government and changes in market conditions are making it more difficult, not less, for consumers to intelligently shop their loans.

The best solution for consumers: Have a real problem solving discussion with prospective loan officers. If you just ask the rate and hang up, the one that low-balls you the most blatantly is likely to get your business, and it will be too late to change when you discover the truth. But if you pay attention to the process they use for putting you into the best situation going forward, then you stand a better chance of discovering their real intentions.

Caveat Emptor

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About this Entry

This page contains a single entry by Dan Melson published on August 3, 2014 7:00 AM.

A Good Listing Agent's Most Difficult Task was the previous entry in this blog.

How to Use Internet Based Real Estate and House Hunting Sites is the next entry in this blog.

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