Recent News On HR3915 To Outlaw YSP, Among Other Things
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 willcome 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.