How Mortgage Rate Discounts Work
What you’re supposed to be getting in exchange for this additional money is an interest rate that is lower than the prevailing rates. The “prevailing” rates in laymen’s terms are those that are most commonly advertised/quoted on any given day for a specific program, borrower, property type and transaction type. Precisely deﬁned, they are the rates at which a given investor will pay full face value for a given mortgage loan on a given day. Got that? I didn't think so. Okay, let me explain…
First, understand that the portion of the points that will go towards the origination fee is decided upon by your lender. Recent changes in the laws regulating mortgage lenders (specifically, the Dodd-Frank Act) have imposed some restrictions upon how much can be charged. The idea was to remove the ability of a lender to reward its salespeople with commission incentives for steering customers into higher-priced programs. But these restrictions do not limit the amount of the origination fee. They only provide that, whatever amount the lender decides to charge, it must be the same for all mortgage products and programs offered by that same lender. So, the commission you pay to a given lender will be the same, no matter what program you choose. But that does not mean you would not be able to find the same program offered by a different lender for a lower price. Since you’re paying for service, the amount will depend upon what competitors are willing to accept in exchange for the same service (provided, of course, that you actually shop around). On the other hand, the points you pay for a discount are an objectively determined, direct beneﬁt to you (or should be, anyway). In an ideal world, you agree upon a given amount for commission, and if you want to discount your mortgage rate, the amount that it costs the lender to obtain the discount should be the exact additional amount you are charged. In fact, that is exactly how it will be, and the new laws require that everything be broken down and disclosed to you in writing. The intent was to provide complete transparency for the consumer. However, the problem is that most borrowers have no idea how this all works, and the required disclosures have become so complex that most people do not understand what they are reading.
Why Purchase a Rate Discount
Remember, all lenders will be selling the mortgages they make and the “secondary mortgage market” consists of investors. They are usually large companies with enormous piles of cash that they need to invest on behalf of their clients. Two of the biggest are now owed by the Federal Government. They are the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. You may know them as Fannie Mae and Freddie Mac. Other examples include mutual funds, insurance companies, pension funds, government and municipal bond programs, etc. It is they who are really calling the shots in the mortgage industry by establishing guidelines under which they will buy mortgages, and thereby deﬁning the types of products that lenders are willing to offer, as well as the rules under which borrowers will be qualiﬁed. Secondary mortgage market investors also determine what price they will pay for a given mortgage on a given date and their pricing is determined by many of the same factors that drive other aspects of the economy. A discussion of those factors is not necessary for our purposes here. It will sufﬁce for you to understand that the big guys behind the scenes are, for all intents and purposes, establishing the rules.
Now, what are the mechanics involved? Figure 1 is a simpliﬁed representation of a lender’s wholesale rate sheet. The left hand column shows a graduated scale of interest rates and the right hand column shows the discount cost (in “points”) at the corresponding rate. Remember, this is the lender’s cost, not yours and he must add to it his commission. Note that as the rate goes down, the cost goes up. At the top, there is a zero in the cost column, which signiﬁes the prevailing or “par” rate for this investor on this date. This is the rate at which the investor will pay full face value for a closed loan. Thus, in this example, if you get a $100,000 mortgage at 4.5%, your lender will be able to sell the note for $100,000. His proﬁt will then be any commissions and fees that he has charged you at close. On the other hand, if the lender writes the loan for a lower rate, then he will have to sell it for some ﬁgure below $100,000 (which is called “discounting” the note) because investors are not in a hurry to invest their money at anything less then the maximum possible yield. The same $100,000 loan, therefore, at a rate of 4.0%, would be discounted by 4% to $96,000. Since the amount of the note is $100,000, your lender will have to collect the difference from you. The lender’s cost, therefore, should be “passed through” to you in exchange for the lower rate. In other words, unlike the points charged for an origination fee, which is paid in exchange for service, discount points are a part of the cost of the money (i.e., they are paid in exchange for the product), and as such should be a “pass-through” cost. What they should not be is a means by which your loan ofﬁcer can increase his commission without your knowledge or consent! Let me give you an example of what to watch out for.
Prevailing Rate (Par)
What To Watch Out For With The Purchase Of A Rate Discount
Now, remember those new laws that require lenders to charge the same commission on all the products and programs they offer? Well, it's actually a bit more complex and involved than it sounds. The reality is that the law is different for different types of entities. So, a bank, for example, has one set of rules and a broker another. A complete discussion of all the intricacies will require an entire book by itself (which is in the works). But, for our purposes here, the only thing you need to understand is that you can still be promised one thing and delivered another without any laws being broken. A salesperson is in compliance with the law if he quotes and discloses a program that actually exists at the time you apply (even if he knows you won't qualify or that he cannot deliver as promised), and it is perfectly legal to change the program any time before the loan closes, as long as all the terms of the change are re-disclosed in writing and the borrowers are given a reasonable amount of time to review and cancel (generally, 3 days).
Remember the “Balance Of Power”? Let’s analyze the situation in light of the previous paragraph and see exactly where it lies now. Mrs. Jumbo has already measured every room in the house and decided what furniture will go where and even ordered some new pieces to ﬁll the empty spaces. She has decided on flooring and window coverings; she bought all new towels, sheets, blankets, etc., to match the new decor. Mr. Jumbo already knows where all of his tools will be placed in their new two-car garage, and exactly how he wants the landscaping; he’s been to Barbecue Bonanza a number of times and has his eye on a beautiful new gas grill for the patio. They have given notice at the place they currently rent, sent out change-of-address forms to all their creditors, subscriptions, etc., and invited everyone they know to a housewarming party two weeks from now. In their minds, the Jumbos have already moved into their new dream home. However, their commitment is not merely emotional, because they put up a cash deposit into escrow when their offer was accepted, and since their loan has been approved, they are now contractually obligated to complete the purchase or forfeit the deposit to the seller. Three weeks have passed since escrow was opened and they are now a week away from the date they must close according to the terms of their purchase contract. If they don’t like the quote their loan ofﬁcer now gives them, what is the likelihood that the market conditions will remain unchanged long enough for them to bail out, start all over again with another lender, get better terms and still close in a week? It seems, therefore, that the balance of power has shifted almost entirely onto the loan ofﬁcer’s side. In reality, the Jumbos can still walk away, but in my 24 years in the mortgage profession, I have never seen it happen. The Jumbos are now totally dependent upon their loan ofﬁcer to make their dream home a reality. They are likely to do whatever he advises and, trust me, he is not unaware of this fact!
Read Next: 8. Mortgage Rate Overage: The Invisible Fee >
< Read Previous: 6. Mortgage Lender Negotiations - The Balance of Power