Higher rate, no fees: Smart move

Continuing our discussion of the recent shelving of proposed changes to the confusing and often expensive mortgage loan closing process: There’s no question that the laws need to be changed, especially those laws pertaining to the Real Estate Settlement and Procedures Act (RESPA).

The plain fact is that there are too many cases where the borrower suffers from sticker shock at settlement. Among other things, the U.S. Department of Housing and Urban Development (HUD) was proposing that service providers, such as appraisers, mortgage brokers and title agents, somehow bundle their services into one guaranteed fee.

Having one flat fee disclosed up front at the time of loan application would surely reduce the cases of settlement sticker shock.

Apparently, the idea was scrapped because some in Congress agreed with many in the industry that such a plan could result in a reduction of competition in the marketplace and thus actually increase the costs of obtaining a mortgage.

Another common but sometimes controversial practice that was addressed was the widespread use of yield spread premiums (YSPs). Simply put, a YSP is a fee paid by a lender to a mortgage broker for delivering a loan with an interest rate that’s higher than a rate that would require fees, or points, paid by the borrower.

I read a newspaper column regarding this practice wherein the writer referred to the YSP as “the amount of interest above the going rate that [the borrower has been] snookered into paying.”

This is plain untrue. Such a statement implies that YSPs are illegal kickbacks.

Let me explain how YSPs really work and why the use of YSPs has been hugely beneficial to American homeowners. I’ll use an example representative of any of the thousands of my company’s customers who have chosen a higher rate with a YSP through the years.

Joe and Liz have a 30-year fixed-rate mortgage at 6.50 percent with a balance of $250,000 on their home. They call a recommended mortgage broker to ask whether it makes sense to refinance.

The mortgage broker gives Joe and Liz three options. He says they can refinance to a new rate of 5.25 percent. Joe and Liz will have to pay all the standard closing costs, such as appraisal, county recording fees, lender’s title insurance, etc. The loan officer says that he will also charge one point in order to make the rate 5.25 percent.

Since one point is equal to one percent of the loan amount, Joe and Liz see that their fees start at $2,500. They look at the good-faith estimate of closing costs, which itemizes the other costs, and they see that the other fees total another $2,300. Needless to say, Joe and Liz aren’t very happy about forking out $4,800 in nonrefundable fees in return for a rate of 5.25 percent.

So the loan officer makes another suggestion. How about a rate of 5.50 percent that carries closing costs but no points? Joe and Liz like this idea better. Jacking the rate up only a quarter percent saves them $2,500 in closing fees.

The loan officer then gives them one last option. Instead of paying even the $2,300 in closing costs, he offers a zero-closing-cost option at 5.75 percent. How can he do this? It’s easy. At a rate of 5.75 percent, the lender pays the mortgage broker a yield spread premium of 1.75 percent because the lender likes to have the higher rate. The mortgage broker calculates the closing costs at about $2,300 so then he figures he can easily afford to pay the borrowers’ closing costs and keep what’s left for the mortgage-broker fee.

Here are the numbers: 1.75 percent of $250,000 is $4,375. The mortgage broker pays all of the borrowers’ settlement charges, totaling about $2,300, and he keeps the difference of $2,075.

Joe and Liz are happy because although their rate is 5.75 percent, they paid nothing out of pocket to obtain the loan, and they didn’t lose any equity refinancing because there were no closing costs to wrap into the loan amount.

They simply converted their 6.50 rate to 5.75 percent and paid nothing. The difference in principal and interest (P&I) between 6.50 percent and 5.75 percent is $121 per month. Clearly, it’s not a bad deal.

That’s why YSPs are good. This option lets borrowers have the choice of taking a rate that’s a bit higher in exchange for the reduction or elimination of closing fees.

Let me be thorough in my analysis for the skeptics. If Joe and Liz had decided to take the 5.25 percent rate and roll in the point and closing costs, would they have been better off?

I doubt it. Here’s why: Adding $4,800 to the loan balance results in a new loan amount of $254,800. The P&I payment at 5.25 percent on $254,800 is $1,407 per month. The P&I payment at 5.75 percent on the original loan amount is $1,459 per month.

So Joe and Liz’s payment is $52 less if they increase their balance and take the lower rate. Does that make it a better deal? Absolutely not. It cost them $4,800 in hard-earned equity to save $52 more each month.

Check out the tax implications. Closing costs are not deductible, and points are deductible only over the life of the loan, making the deductibility of the $4,800 virtually meaningless.

However, the extra interest paid each month by taking the higher rate can add up. A quick rule of thumb would be to discount the $52 by 20 percent (52 times 0.8). This means the after-tax difference in monthly payment between the two loan programs is only about $42 per month.

Here’s the bottom line: Are Joe and Liz prepared to pay $4,800 to save what amounts to only $42 per month? Divide the $42 savings into the $4,800 in cost, and you find that it takes 114 months, or 91/2 years, to recoup the costs.

So if Joe and Liz are 1,000 percent sure they are not going to sell their house, and if rates never fall from the current levels in the next 91/2 years, they ought to fork out the dough and take the lower rate.

Statistically, people don’t hold loans that long. If the loan is paid off before the break-even period, Joe and Liz have lost money.

That’s why YSPs are a good thing. This option allows borrowers to obtain a mortgage without having to pay huge nonrefundable fees. The so-called experts who preach that YSPs are a rip-off to the consumer simply don’t know what they are talking about.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavage@pmcmortgage.com).