I lived in California for several years and had no idea that people were growing it in their back yards in the Northern Part of the state, with little, if any resistance from law enforcement. Learn more about what they call the “Marijuana Triangle” tonight on CNBC. Check your local listing for showtimes.

From the CNBC website:

While it may not be traded on Wall Street any time soon, marijuana has become a booming cash crop. CNBC’s Trish Regan goes behind the scenes to explore the inner workings of this secretive industry, focusing on Northern California’s “Emerald Triangle,” now the marijuana capital of the U.S. In this scenic pocket of America, the pot business, much of it legal under state law, now makes up as much as two-thirds of the local economy.

Marijuana Inc [CNBC.com]

Ringleader Matt Cox made off with around $12 million and, in a telephone interview with CNBC, explains the details of his crime.

Check out CNBCs American Greed site here. Their site lists showtime at 9p | 1a ET, but I’m on the east coast and my guide has it listed at 10:00pm, so you may want to set your DVR so you don’t miss it, or check your guide.

Mat Cox - Mortgage Broker & Ringleader

Alison Arnold - The Ex-Girlfriend

Rebecca Hauck - Partner-in-crime

Madoff is the founder of Bernard L. Madoff Investment Securities LLC and separately managed money for high-net-worth individuals and hedge funds through an investment advisory business he oversaw. Madoff was charged with securities fraud on Thursday after federal investigators called his operation “a giant Ponzi scheme.”

According to The Wall Street Journal, Madoff was buying and selling options, which are orders that allow someone to buy or sell stock at a given price within a given time frame. The orders don’t have to be placed. The Wall Street Journal Weekend Business Podcast for 12/12/2008 states that, while buying and selling options is a viable investment strategy, it would be impossible to execute given the enormous amount of money Madoff was managing.

What is a Ponzi Scheme?

Ponzi schemes operate on the promise of high rates of return with little risk; no different from most investment schemes in that regard. In a Ponzi Scheme, however, portions of new investors’ funds are siphoned off and paid as returns to older investors. Older investors think they’re getting great returns when the money is actually coming from the new investors. In the end little, if any, real investment actually takes place. The scheme is able to operate as long as there is a constant flow of new investors; as soon as new investment slows or stops, there is no longer money to pay the older investors. We may find that this is just how Madoff got caught…with the slowing economy, he no longer had a steady flow of new investments to pay the old investors. This is just speculation of course, nonetheless, this appears to be the largest investment scam in U.S. history, causing irreparable losses to thousands, including many large charities.

First Of All, What Are Points?

If you’ve read through the glossary, you may have come across the definition of Points. What you may have noticed is that the only real definition of a Point is a percentage of the total loan amount. The term points doesn’t necessarily mean closing costs, or rebate, or discount costs. Rather, quite literally, 1 point is equal to one percent of the loan amount. The problem with the idea of “paying points,” is that the phrase means, literally, “paying a percentage of the loan amount.”

What’s Really Wrong With The Promise of “No Points?”

The problem lies in the fact that “Points” is not the same as “Closing Costs,” something a lot of mortgage shoppers would be surprised to learn. So, promises of a refinance with no points makes great advertising and generates phone calls, but it does not mean there are no closing costs. It’s not what the promise of no points does say, but what that promise doesn’t say that makes this a form of bait and switch. The promise of no points says you won’t pay a percentage of the loan amount in closing…great, but it doesn’t say you won’t pay any up front closing costs, it also doesn’t say that your lender or broker can’t give you a higher interest rate and make you pay closing costs indirectly.

Understanding The Bigger Picture

When shopping for the best mortgage terms available, the focus should be on interest rate and total closing costs instead of terms like points, which may very well be so emphasized these days as nothing more than a marketing ploy. Mortgage companies understand that the average consumer doesn’t understand the details of a mortgage transaction well enough to recognize such ploys. An adequate understanding of the details of a mortgage transaction is essential if one expects to really find the best deal.

If you follow the mortgage or real estate markets at all you’ve probably heard about HR3915, the new proposition to, among other things, outlaw Yield Spread Premium (YSP) in mortgage transactions. If you haven’t heard about it, just do a Google search on HR3915 and you’ll find quite a bit about it. If you want to read the actual resolution itself, you can find it here…HR3915. So let’s break down yield spread premium and whether it’s a good or bad thing.

Yield Spread Premium, What Is It?

YSP, or Yield Spread Premium, is a term familiar to mortgage brokers and those home-owner’s who’ve done business with a mortgage broker. Essentially, YSP is a premium paid by the bank as a result of the broker/borrower accepting a higher interest rate than “par.” If you don’t know what I mean by “Par,” you can read a bit about the interaction between points and rate in this post, but I’ll give you a brief refresher here.

Interest Rate – Loan Cost Interaction Refresher

When I shop for a loan for a client, the bank gives me options as to how I want the loan priced. Aside from all the traditional factors affecting interest rates and loan costs, the bank gives me, and hence my client, two numbers that we can play with to change the interest rate and closing costs of the loan. Those two numbers are points and interest rate, and they vary inversely, in other words, when one goes up, the other comes down.

If I have a client who wants the absolute lowest interest rate offered by a given bank, also called the “floor,” the bank will accept money up front to essentially allow the borrower to buy the rate down; the money the bank accepts is referred to as points because the cost to buy down the interest rate is represented by a percentage of the total loan amount.

So, that’s what’s known as paying points, the opposite is known as a rebate; also called Yield Spread Premium, or YSP. Let’s say my client doesn’t want to pay any closing costs at all; without YSP, that’s impossible. There are costs associated with a mortgage transaction that no amount of wishing and hoping will make disappear; there are several people that work on any given mortgage transaction, and all those people get paid through the profits on the loan. However, YSP allows me to set up a situation for my client in which he or she won’t have to pay any closing costs, or so it appears, let me explain.

Generally, on any given mortgage transaction, a homeowner can expect to pay $3500 or so in total closing costs; the money will be paid, and it will come out of the homeowner’s pocket, there’s just no way around it. There are certain situations, however, in which a homeowner would benefit from not paying any up front costs for a mortgage. Yield Spread Premium allows us to accomplish that; in exchange for a slightly higher interest rate, the bank will pay a rebate on the mortgage transaction; the amount of the rebate depends on the amount of the rate increase. If my client wants no out-of-pocket closing costs, we increase the rate slightly, receive a rebate, and the rebate pays for the borrower’s closing costs as well as compensation to those who worked on the loan.

I mentioned “par” earlier; the par rate is the rate at which the borrower qualifies without paying any points and without receiving any rebate. If we want to pay points, we can get a rate below the par rate, and if we want to receive a rebate, or YSP, we get a rate above par. It’s important to keep in mind that the par rate is not going to give the borrower a no-closing costs loan, the borrower still has third party fees and broker fees to pay.

How Yield Spread Premium Affects Homeowners

Now that we’ve had our interest rate/loan cost interaction refresher, we can understand how YSP affects you, the homeowner. Let’s start with the good side of YSP – when it’s used responsibly by the broker.

When YSP Is Used Responsibly

Let’s say I have a client named Joe who plans to move in a year, but his mortgage rate is about to adjust and he doesn’t want to get smacked with ever-increasing payments. I’d usually recommend to Joe that he not pay any points, and, in fact, no out of pocket costs at all, and, instead, accept a slightly higher interest rate, and here’s why.

Let’s say Joe’s third party closing costs (Title, Escrow, Recording, etc fees) are $3,500. Let’s also assume that Joe has great credit and qualifies for a 6% interest rate at par (no points, no rebate). To close that mortgage transaction, Joe is going to have to pony up the $3,500 either out of pocket, or it will be rolled into the loan amount, in addition to my compensation. Now, let’s also assume that if Joe was willing to accept a 6.5% interest rate, the bank would pay a rebate of 0.875% of the loan amount (this rebate is YSP). If Joe’s loan amount is $600,000, that 0.875% rebate would amount to $5,250, which, in Joe’s case, may be enough to cover all of his $3,500 in third-party fees as well as my fee. So, Joe gets a no closing cost loan, but was it worth it to take a higher interest rate? Since Joe plans to move in a year, it probably was; let’s take a look.

Was Joe Better Off With No Closing Costs And A Higher Interest Rate?

That extra 0.5% on the rate will end up costing Joe $250 a month, which, over the course of the next year will add up to $3,000. But remember, the bank paid us a rebate of $5,250 (again, this is rebate is called YSP, or Yield Spread Premium), which Joe used to cover all of the costs associated with his refinance. So, if Joe sells in one year, he effectively traded $3,000 of his own money for $5,250 of the banks money; sounds like a pretty sweet deal to me, and Joe ends up with an extra $2,250 in his pocket ($5,250 – $3,000).

If, however, Joe decides to stay in the home for two years instead of the originally-planned one year, he’ll actually be worse off by accepting the higher interest rate. Over two years, that extra $250/month on the payment will add up to $6,000, so if Joe told me he’d be staying in the home for two years instead of one, I wouldn’t have recommended taking the higher interest rate.

What If YSP Is Not Used Responsibly?

By law, a broker has to disclose YSP on your final loan documents; so you can find out exactly what rebate was paid by the bank, if any. The problem is, if you’re like most homeowners, this is the first time you’ve ever heard of YSP and how it’s used; this opens up a world of possibilities for unscrupulous brokers to use YSP for their own gain.

For example, let’s say instead of me, Joe decided to do business with a shady mortgage broker, let’s also say that Joe was completely dead-set against paying up-front costs, even though he’s now decided to remain in his home until he retires, another 25 years. If Joe’s so against paying points, that shady mortgage broker will have Joe pegged within 15 seconds and know exactly what to say to get Joe to bite. Joe will probably tell the broker about all the other companies he got quotes from that offered low closing costs, but Joe didn’t want to hear any of it, he had his heart set on no closing costs. So, the shady broker sympathizes with Joe, he says thinks like, “Wow, I can’t believe no-one was willing to offer you a free loan. I’m sure all those guys were just trying to take advantage of you and get you to pay points that you didn’t need to pay in the first place.”

Joe likes the sound of this, “this is my type of guy,” Joe thinks to himself. So, the shady broker goes to work shopping for the loan that’s going to give him the biggest payday. The broker comes back with an interest rate a bit higher than the other companies came back with, but the broker knows that Joe is so dead set against paying up-front costs, that he’d rather accept a higher interest rate than pay any up-front costs. Also, the shady broker mentions that those other “evil” companies ran Joe’s credit so many times that his score dropped and, because of that, the rate is slightly higher, but “No fear!” the shady broker exclaims, “The higher rate is hardly going to cost anything extra each month and I got what’s really important for you, Joe, no up-front costs.”

Now Joe’s happy, he’s got what appears to be a no-closing cost loan, he signs the documents, and the deal is done. It’s likely that Joe won’t ever realize what happened, because he doesn’t fully understand how the mortgage industry works, and that’s what his shady broker was counting on.

So what’s actually happened here? Let’s say the broker decided to jack the rate up to 7%, take a 1.5% rebate from the bank, and pay Joe’s closing costs from the rebate. The YSP paid to the broker, at 1.5% of the loan amount, would be $9,000; after closing costs, the broker walks away with $5,500 in commission; none of which Joe will actually ever realize he paid. Instead, Joe will assume he got a “free loan,” and since all those other companies ran his credit, the score dropped, so he got stuck with a higher rate, but what’s most important to Joe is that he got his “free loan.” Now, remember that I would have recommended, if Joe were going to stay in the home for more than a year, to pay some closing costs in exchange for a lower interest rate? Let’s see just how much this “free loan” actually costs Joe.

At 7% on a $600,000 loan, Joe ends up paying an extra $500/month than he would have if he took the par rate of 6% based on my recommendation (since he’s now decided to stay in the home until retirement, another 25 years). Over the next 25 years, the extra interest at 7%, as opposed to 6%, will cost Joe $150,000! So, Joe just gave the bank $150,000 in exchange for the bank saving him around $5,000 in total closing costs…I’m sure if Joe were aware of this he would have paid the up-front costs.

Should We Outlaw YSP?

That depends on who you ask. YSP can be used to take advantage of unsuspecting borrowers, but then again, so can any other aspect of the loan process borrowers don’t understand. If we’re all so worried about being taken advantage of, why don’t we just lock everyone up in a padded room and have guys in white outfits feed trays of food through slots in the door. The fact is, when you walk out the door in the morning, you run the risk of being taken advantage of, but most of us protect ourselves, and you know how we do that? We educate ourselves (or someone does it for us).

You don’t hand over a $100 bill to a stranger on the street just because he tells you he’ll turn it into $1,000 do you? No. And why don’t you? Because you’ve learned, either through your own mistake or someone else’s, that it’s a bad idea; this seems such a basic concept to us that we don’t even think about it, but at one point, we learned not to do this.

The solution is not to outlaw YSP, which, in Joe’s case above could have saved him quite a bit of money in the event he moved out of his home in a year’s time; the solution is to educate borrowers on YSP, require full disclosure of YSP, and enforce some of the lending laws that already exist. Listen, adding more laws and more restrictions when we don’t even enforce the ones we already have is a little more than nuts, especially when the thing you’re trying to outlaw is a pretty important money-saving tool when used correctly.

What To Do Now

At this point, I recommend you do two things. The first is to sign this online petition against HR3915. The second is to call your local congressman/woman and voice your opposition to this bill (if you’re only going to do one thing, do this, it will be way more effective than just signing the petition).

If you’d like to read the bill itself, you can find it here. Read the original HR3915.

To make things simple, I’ll use the mortgage rates and loan amount from the post about paying points to refinance. In that particular situation, paying $9,600 in points upfront on a $600,000 loan would save the borrower $300 a month on his or her monthly payment. As a result, the buy-down cost of $9,600 would pay for itself in a little less than 6 years; so, the cost would be worth it if the homeowner expected to remain in the home for more than 6 years. That’s just one side of the story, there’s another side that most people don’t think about.

Put the Savings Toward the Loan

Ok, so if you don’t pay the points, you’re payment is $300/month more than it will be if you do pay the points, so, if it’s up in the air and you can afford to make the higher payment, you should factor in one more thing. Since you were considering the higher payment anyway, what if you were to pay the points and put the $300 savings toward an extra principal payment each month? Well, at the end of the 6 years, the roughly $20k cost will be returned, but what if you then decide to stay in the home until the loan is paid off? At the end of 30 years, you’ll have saved $135,911 in interest payments and you’ll pay off your home 8 months faster!

In Layman’s Terms

So basically, it boils down to this: In this particular situation, if you’re going to stay in the home for at least 6 years, it will benefit you to buy down the rate, but every month you stay in the home past 6 years, you’re going to see extra savings that you wouldn’t have seen had you not paid points for the lower rate.

The Investment Approach

The other option is to pay the points, buy down the rate, save $300 a month and, instead of putting that money back into the loan, you invest the savings. At a measly 4% return, $300 a month will turn into $24,746 after 6 years, $44,619 after 10 years, and a whopping $209,188 after 30 years. You shouldn’t have any problem finding an investment that will pay a 4%.

Now, more realistic returns on, say, the stock market would be around 8-12% – let’s call it 10% for the sake of the demonstration. Investing $300 a month for 6 years at 10% would give you $29,965, after 10 years you’re looking at $62,232, and after 30 years that little ‘ole $300 a month turns into $683,381!

Obviously the investment approach yields the greater benefit and, in fact, the roughly $20k cost of the loan we covered earlier would pay for itself a bit sooner than 6 years using this approach.

It’s All in the Numbers

In California, a $600,000 loan is quite common; ultimately, how the numbers work out will completely depend on your situation and these calculations need to be made by you, your financial advisor, or your mortgage advisor. Whoever does the math, it needs to be done, we’re talking about a lot of money here. So quit sitting on your butt and get to it!

No Such Thing As A Free Lunch

Ever heard the saying, “There’s no such thing as a free lunch?” Well there’s no such thing as a free mortgage either; think about it, there’s a lot of work that brokers and banks put in to helping you refinance. Do you think these people are working for free? They’re definitely not. So, what is a “free loan” really and how does it differ from a loan with closing costs?

Scenario 1: Let me give you a little info on how I price a loan with a lender to help you understand this. Lenders allow borrowers to pay points upfront in exchange for a lower interest rate; the opposite holds true as well: lenders will pay a rebate in exchange for a higher interest rate. So, let’s say you want to refinance your house and you’re willing to buy the rate to the “floor” (the lowest rate the lender has available); such a refinance can cost a lot of money upfront. As of today, for example, a borrower with a loan amount of $600,000 can get an interest rate of 5.75% at a cost of 1.6 points, or about $9,600 – not including other closing costs, which can run another $9,500. As I write this I can just picture you shaking your head saying, “There’s no way I would pay almost $20,000 to refinance my house!” No problem, let’s see what kind of rate we can get “for free”.

Scenario 2: As of today (remember, rates change every day), that same borrower can get a loan with absolutely no closing costs at a rate of about 6.75%. How are there no closing costs? Because in exchange for accepting a higher interest rate, the lender will pay a rebate of about 1.5 points (1.5% of the loan amount), or $9,000. That $9,000 will go to pay for your closing costs so you don’t have to.

The Free Loan Myth

So, the question is, “Is the loan really free?” Well I’ve already told you no, but let me prove it to you.

In scenario 1 above, your monthly payments would be around $3,600 a month. Scenario 2 would give you payments of around $3,900 a month because of the higher interest rate. So, why would anyone pay $20,000 to save $300 a month? When the cost of the buy-down pays for itself before you refinance again. If you take the cost of the buy-down, $20,000, and divide by the monthly savings of $300, you find that it will take about 67 months (5 years, 7 months) to break even. Obviously if you’re only going to be in the house for another 3 years, the buy-down isn’t worth the cost, but what if you are refinancing into a 30 year fixed and don’t have any plans to move in the future? In this case, the buy-down saves you $88,000 over the life of the loan and gives you a lower monthly payment.

So, next time you see one of those TV commercials advertising a no closing cost loan, remember, there’s no such thing as a free lunch. A good mortgage broker will be able to calculate the best option for you based on your goals.

That’s right, I’m sure you’ve heard this before, but probably didn’t realize that it applies to mortgages also. Not just mortgages, actually, but mortgage brokers. Before I go any further, I should mention that most people don’t realize exactly what a mortgage broker does. When most people think about shopping for a mortgage they think about calling several banks, getting quotes on the current rates, and picking the lowest one. Makes sense, right? Sure, but let’s say you submit an application on LowerMyBills or LendingTree to find the best rates available. Most of the companies calling in response are mortgage brokers, not banks. If you’re not sure what a mortgage broker is, I’ll write a post soon about the difference between brokers and banks.

If you didn’t know this, don’t worry; those websites don’t exactly clarify. I mean, seriously, LendingTree advertises having banks compete over you. Banks…they never mention brokers.

So anyway, a bunch of mortgage brokers call you and try to earn your business – you ask each of them what their rates and closing costs are. Well, brokers can charge whatever you’re willing to pay – assuming it’s within the guidelines of the law. On the other hand, a bank may have a standard fee that they charge on a given loan. So, you have a lot more room to negotiate with a broker than you do with a bank. So negotiate those fees down as far as possible and make sure you get the best deal, right? Wrong.

Remember, you get what you pay for.

Negotiation is fine and dandy, but that broker has to feel like doing business with you is worth his time; and if that broker is good, then his time is valuable. So what happens when you make it clear that you’re not willing to pay that 1% or 2% broker fee? The broker decides the deal is not worth his time and moves on. Suddenly you’ve weeded out the best of the best, and the only broker left is the one that’s willing to do the deal at little cost; and since you don’t get good for cheap, that broker probably isn’t the best. If you refinance more than a few times in your life, a good broker can be worth his weight in gold.

Why am I telling you this? Because every day I speak to potential clients, and every day I see clients go with other brokers who offer their services at very little cost.

So, by trying to pay the least closing costs possible, you’ve weeded out the best brokers, and only the worst remain to do business with. Not only that, but, unfortunately, there are a lot of unscrupulous brokers in this business. Some of these brokers are willing to lie, cheat, and steal to make a buck. I’ve had people chose another broker over me because that broker offered a seemingly unbeatable deal that I knew wasn’t real. The only thing I can do in that situation is tell the client that I don’t think the deal is a valid one and that I’d be there to help them if things turn out to be different; sometimes they come back after already having spent a lot of time and $300-400 on an appraisal that the dishonest broker now owns. It usually isn’t until they get to the signing table that they realize things have changed. By then, some clients have invested so much just to get to that point that they sign anyway.

So, how can we get the best deal on a mortgage and avoid all these potential problems? Well, we’ll cover that in the next installment.