How Loans are Priced – PT 1: Compensation
Christopher Shank – NMLS 2562885 – Follow the Dollar
Hey folks.
This here is THE transcript to THE video that everyone’s been waiting for, the one where I break down how loans are actually priced out. Before I begin, I want to thank you for your patience- this is a rather advanced topic, and I had to set the stage with some of my previous videos, especially the one about mortgage backed securities, to help you better understand some of these concepts. I hope you’re ready to follow that dollar!
First off, we need to go over a few definitions.
QUICK DEFINITIONS
In the world of mortgages, there is a unit of measurement called a BP, which is most commonly pronounced “bip”. One bp is equal to one one hundredth of a percent of the value of a loan. This means that on a two hundred and fifty thousand dollar loan, one bp is worth $25.
One hundred bps is known as “one point”. Going on our earlier math, if one bp is worth one one hundredth of a percent, one point is worth one percent of the VALUE of a loan.
1bp = 1 “bip” = .01% of the Loan Amount
When someone talks about buying down your interest rate, they’re referencing points, but to avoid confusion, most loan officers refer to these as “discount points”. As a general rule of thumb, for every discount point that you buy at closing, you can expect your interest rate to drop by a quarter to a half of a percent. There are some serious limitations to this rule, but we’re going to be covering this in more detail later.
100bps = 1 point = 1 “discount point”
On to the meat and potatoes.
As we learned in our episode about mortgage backed securities, mortgage companies have to set their rates very carefully. If they offer a rate that is too low for the market, that particular loan will have difficulty being sold on the secondary market because investors tend not to invest in options that are projected to underperform. If, on the other hand, a mortgage company offers a rate that is high for the market, they certainly won’t have troubles finding a buyer on the secondary market, but instead, they might struggle to find customers willing to finance a loan with that high a rate.
Competition between lenders is fierce. As a matter of fact, if you were to make a distribution graph and plot the base price of mortgage rates between one hundred companies, the vast majority of these lenders would offer base rates within half a percent of one another.
Now, I know what you’re thinking. Chris, if you’re telling me that most lenders have similar pricing, why did I get three drastically different quotes from three different loan officers? Well, dear viewer, the answer is quite simple- it’s money.
Below is a modified pricing table for an FHA loan with a value of a tad over three hundred thousand dollars. For clarity’s sake, this table was for a loan that was priced back in April. For the sake of our examples, we’re going to just round down to three hundred thousand dollars. Yeah, I know it looks confusing, but let’s take it one piece at a time.
The left column lists interest rates in one eight percent increments. The middle column lists the number of points that it would cost to secure that rate, while the right column translates these points into dollar amounts.
When I look at this chart, the first thing that I do is to find the par rate. This is the point in which a loan is written whereby a client pays no extra points for their rate, nor gets a lender credit. Because most lenders offer rates in one eighth percent increments, the par rate usually falls between two rates. In this example, the par rate is somewhere between 5.875% and 6%. Not to put too fine a point on things, but the par rate is one of the most important values in your loan.
Now, for the sake of continuing our example, let’s say that our lender won’t let us settle on the true par rate. In this case, you’d have to decide whether to take a 5.875% rate and pay $402, or you could take a 6% rate and secure yourself $1495.61 in lender credits, which could go toward paying down your closing costs. If you, continuing this example, wanted to get to a 5.5% percent rate, you’d have to instead come to the table with a little over $4k to buy that rate down 1.2 points.
But wait, there’s more! What if I were to tell you that three different loan officers could use the SAME lender and the SAME pricing table, and STILL give you three different rate quotes? Here’s the truth folks, it happens EVERY day. Let me show you by following that dollar.
When you buy a home, your realtor is entitled a commission for the work they did to find you said home and handle all the administrative work on the back end to ensure that you actually get that home. In most cases, while your realtor will see a sizable chunk of this commission, a notable sum goes to their brokerage to cover various fees and operating expenses. The same thing happens when a loan officer originates your loan- they receive a commission for their work, and the company they represent also gets a cut as well.
Most lenders are VERY close to the vest about what they earn on a loan, and I can’t blame them. A LOT of effort goes into writing a loan, but a loan officer’s position in the transaction is not guaranteed. Think of it like this- say you put an offer on a house and agreed to pay your realtor a three percent compensation. The following week, you meet a realtor who says that if you use them instead, they’d only charge you two percent. Depending on the wording of your buyer’s agreement with your current realtor, if you were to fire your current realtor in favor of the cheaper realtor, you could be legally obligated to pay the first realtor damages or find yourself on the wrong end of a lawsuit. If, during the loan process, you switch to a loan officer who quotes you a lower compensation, there’s not much the first loan officer can do to recover from those lost hours and resources.
There have been attempts to study the average lender compensation that’s earned on a loan, but because of how tight most lenders are with their compensation, most of these studies have come back… less than insightful. Still, most loan companies charge around two and a half to three percent compensation from a loan, though it’s up to the company itself to determine how much of that compensation that the loan officer receives. In my time as a loan officer, I’ve met other officers who earned almost three percent compensation on a loan! I’ve also met loan officers who made as little as three hundred dollars per file. Heck, I know of a company that pads about an extra percent’s worth of fees into their pricing to cover their advertising expenses and the bonuses they pay to their leadership
Okay, now we’re putting you in the shoes of a loan officer. Let’s say that you work for a company called Awesome Loans Incorporated, and you’re pricing a $300k loan for a client named Bob. For the sake of this example, you’re using the rate sheet above to calculate his pricing. ALSO, for the sake of this example, your company charges two percent compensation for all loans that they write- half goes to you, half goes to your company.
Now, simple math tells us that two percent of $300k is six thousand bucks. Using the chart, you can determine that you can get him a loan at 5.875%, and all it will cost him is $402 for the slight buydown, plus $6k for your company’s compensation. For full transparency, this is called borrower paid compensation, because the borrower is, well, paying your compensation. Anyway, Bob thanks you for your time and you never hear back from him again.
Wait, what? You see, borrower paid compensation is awesome because it allows you to be fully transparent about what you’re charging. It also gives EVERY other loan officer out there the exact number to beat in order to win Bob’s business over. Additionally, Bob might not have six thousand dollars to pay your compensation. Because of this, Charlie over at Pretty Good Loans was able to convince Bob to work with him instead because he promised he wouldn’t charge Bob a cent in origination. Yeah, he’s going to have to charge him a 6.875% interest rate, but oatmeal is better than no meal, right?
Distressed and half convinced that Charlie is using black magic to steal your clients away, you consult the rate chart to find where you went wrong, and your eyes focus on the negative dollar amounts listed on the entries underneath the par rate. These values represent lender credits, and can be credited to the buyer to offset loan expenses, such as closing costs. You know that you have to make $6k on a loan to satisfy your company, so you look down the chart until you find a rate that gives at least that much in lender credits, which correlates to 6.625%. You call the lender, and they agree that they will allow you to use $6k worth of lender credits to pay your commission. Even better, because the LENDER will be paying this commission, you don’t have to put that commission on Bob’s loan documentation, so it’s like that cost didn’t even exist in the first place! Congratulations, you just discovered something called lender paid compensation.
Anyway, now you know what you have to do. Determinedly, you rush out the door and spend seven years in the Sahara in search of a magic lamp. Finally finding one with only one wish left, you ask the genie to send you back in time to right before you made your offer to Bob.
BOOM! With a snap of the genie’s fingers, you’ve been sent back in time. Excitedly, you call up Bob and make him an offer. You’re able to offer him a 6.625% interest rate AND over $1.1k worth of lender credit to reduce his closing costs. You’re a hero.
Now, ask any one of my clients or realtor partners- I’m 100% transparent about what my compensation rate is. That said, I’m a huge fan of lender paid compensation because it allows me, as the loan officer, some interesting levels of maneuverability. For example, let’s say that you’re Bob and I’m your loan officer. Because I’m so involved in your file, I know that your seller concessions will be able to completely cover your closing costs, which means that the eleven hundred dollars of lender credits might go to waste. Knowing this, my relationship with the lender empowers me to negotiate on your behalf, and I might very well be able to get your rate dropped from 6.625% down to 6.5%. Maybe I was able to do this by leveraging the lender’s good will. Maybe I did it by dipping into my own compensation to make this happen. Regardless, all Bob will know is that, at the end of the day, I dropped his rate down to six point five percent and his seller concessions completely covered his closing costs.
Wow, I sure can talk (or write) a lot! I’m going to break this lesson into two videos, there is a LOT to cover here. Today, we covered how loans are priced and how lenders use buyer paid and lender paid compensation to get you the rates at which you finance your major purchases. Next up, we’re going to talk about discount points and how to buy down your rate to keep your mortgage payments as low as possible. I’m Chris Shank with Mortgage Advocacy and together, we’re following that dollar.