How loan originators are compensated and why consumers should care.

The Merkley Amendment to the Wall Street Financial Reform legislation limits loan originator compensation to no more than 3 percent of the loan amount. If you want to debate the Merkley amendment, please visit this thread or this thread. From the Mortgage Banker’s Association, here is a summary of how loan originator compensation would be limited under the new Dodd-Frank Wall Street Reform Act HR4173

Prohibition on Steering/Loan Originator Compensation – Establishes new anti-steering restrictions for all mortgage loans that prohibit yield spread premiums and other compensation to a mortgage originator that varies based on the rate or terms of the loan. Would allow compensation to originator (1) based on principal amount of loan, (2) to be financed through the loan’s rate as long as it is not based
on the loan’s rate and terms and the originator does not receive any other compensation such as discount points, or origination points, or fees however denominated, other than third-party charges, from the consumer (or anyone else), and (3) in the form of incentive payments based on the number of loans originated within a specified period of time. Expressly permits compensation to be received by a creditor upon the sale of a consummated loan to a subsequent purchaser, i.e. compensation to a lender from the secondary market for the sale of a consummated loan but creditors in table funded transactions are subject to compensation restrictions.

All fees that enure to the benefit of the lender (the entity funding the loan) as well as any third party mortgage broker, now appear in box 1 of the Good Faith Estimate.  The loan originator rarely if ever is earning the total dollar amount in that box. Instead, the loan origination fee is divided up between different people. If the massive Wall Street Reform law passes, loan origination fees would be capped at 3 percent of the loan amount, with some exceptions: 

3 Percent Limit – Definition in TILA with the following exclusions (1) bona fide third-party charges retained by an affiliate (2) up to and including 2 bona fide discount points depending on interest rate. Also, excludes any government insurance premium and any private insurance premium up to the amount of the FHA insurance premium, provided the PMI premium is refundable on a pro rata basis,
and any premium paid by the consumer after closing

Consumers have ample opportunity to shop for mortgage rates on the Internet and hear radio advertisements all day long for refinance “rates as low as….” however low they might be that day.  We would all hope that consumers are much more savy mortgage shoppers when compared with the peak of the real estate bubble.

Some loan originators believe consumers do not care what their loan originator is paid as long as the consumer receives the lowest possible rate and fees available on that particular day for his/her particular loan needs.  I happen to believe the opposite is true, with one twist. Consumers do care what loan originators are paid, when they are educated as to how to understand LO compensation.  

Some loan originators hold an irrational belief that consumers couldn’t possibly care about their compensation…that consumers ONLY care about getting the lowest rate because their note rate is the single most important thing affecting the monthly payment and their monthly payment is typically a homeowner’s biggest check he/she writes every month.  However, it’s important for LOs to understand that they have a vested interest in keeping consumers in the dark about how and how much LOs are compensated. If consumers were to fully understand LO compensation, consumers would have the ability to better negotiate a lower fee.  Since many consumers roll their closing costs into a refinanced loan, this *does* affect a person’s monthly payment because the consumer is amortizing the loan originator’s fee and paying a little part of it each month.

If consumers were forced to pay their closing costs in cash up front at the close of escrow on a refinance, consumers might suddenly become much more interested in understanding how to shop for all the settlement costs. 

The mortgage industry trained Americans to serial refinance with very little out of pocket expense and to purchase a home using 80/20 loans with sellers paying all their costs.  We’re now requiring more money up front on a purchase money loan but many buyers are still in the driver’s seat asking and getting seller concessions and many consumers still refinance by rolling all their closing costs into the new loan.

There are many different ways loan originators are compensated. Here are a few:

Percentage of the loan amount
If the loan amount is $350,000 and the loan origination fee quoted is 1.75 percent, your loan originator is likely not going to take home a $6,125 paycheck.  Typically a loan originator is going to split that $6125 with his or her company in some way.  It might be a 50/50 split or perhaps some loan originators will get a better split if they are bringing in their own clients. 

On that same transaction, a loan originator may have been able to sell you a slightly higher rate than what you could have received had you known a better rate was available that day.  When a loan originator works for a bank OR non-depository lender such as a mortgage bank (no checking and savings) this is called earning “overage.”  This LO is going to earn an additional .50 percent of the loan amount in extra compensation that he/she does not have to disclose to the consumer.  On our sample transaction, that comes out to be an extra $1750. This may or may not have to be split with the loan originator’s company. 

When a loan originator works for a mortgage broker, all compensation, including any “overage” which is also called “yield” or “yield spread premium” is disclosed to the borrower on line one of the good faith estimate and the consumer is shown, on the GFE that the consumer is choosing a slightly higher rate in order to pay his/her loan originator this extra compensation.

Before the 2010 changes in how compensation was disclosed to consumers on the good faith estimate, loan originators might have earned even more compensation through processing, underwriting, and administration fees. There’s nothing wrong with these fees, provided there was actually an underwriter, processor, and administrator doing work for that fee.  With the new 2010 good faith estimate, all these fees are now disclosed on line one of the GFE.

Besides receiving a split of the origination fee, other ways of LO compensation might be paying LOs based on the total volume of loans and/or total loan amount each month,  an hourly wage with a bonus, a salary, or a combination of different methods.

What’s a fair way for consumers to negotiate loan originator compensation?

Fair can be defined in may different ways. Some LOs prefer to always charge the same percentage of the loan amount:  1 percent, 1.5 percent, 2 percent, and so forth, for all their clients.  Yet some LOs believe that’s not fair.

Why should one customer who’s loan amount is $350,000 pay $6125 (1.75%) and another customer whose loan amount is $600,000 pay $10,500 (1.75%) and another customer with a $100,000 loan pay $1,750 (1.75%) 

Suppose the person’s loan who paid only 1,750 took more time and effort than the person who paid 10,500.

Why should the consumer paying $10,500 help subsidize the price of the loan for the guy who needs constant handholding?

If a loan originator works hard trying to find the best loan program or the absolute lowest rate (so the consumer does not have to spend time shopping) and she put in all kinds of time and effort, this LO is arguably worth more to the consumer.  This is the broker model of originating loans.  The mortgage broker LO acts as a third party middleman, an “agent” for the borrower, and helps the consumer select the best fit from lots of different mortgage money choices.

Conversely, some consumers are anal retentive (nothing wrong with that. Takes one to know one) and like to do all kinds of research, spreadsheets, analysis, interviewing, reading and experimenting on their own, sometimes for many weeks or months.  By the time this person is ready to select a mortgage, the AR borrower has already selected the mortgage product, rate, and company. This obsessive compulsive has even run a background check on the firm and its history of consumer complaints, knows the name of the CEO, where her kids go to school, what type of loan she currently has on her own home, and what paperwork will be asked of him at application.  Arguably this customer has already done most of the loan originator’s job (in his opinion), so why should he have to pay a heft LO fee if he’s just going to fill out an online Internet application, send in a package of paperwork, and close “in as little as 2 weeks?”

Well, anyone in the mortgage lending industry knows that the borrower in the mortgage broker scenario could end up being a bunny file, where the broker/LO only spends 5 hours max on that file whereas mister anal retentive’s file ends up being the nightmare scenario from hell and the low-fee company ends up losing money on that transaction. 

I take these two polar opposites as examples because a loan originator’s real life is some of the above but mostly everything in between.  A loan originator never really knows for sure how much time he/she will spend on a particular file.  This is one of the reasons (I’m sure there are others) why LOs simply revert to a percentage of the loan amount: Because everything washes out in the end.

Today’s consumers are left wondering what the hell happened during the meltdown and really don’t buy any of the crap the industry tries to use to brainwash the world into thinking it wasn’t the industry’s fault. “It was the rating agencies,” or “those greedy Wall Street investment bankers are to blame,” or “It’s the big banks: They are the ones who told us to sell the toxic mortgages.”  Somebody needs to tell the industry that the more the industry tries to shirk all responsibility, the more guilty the industry looks. The more the industry points outward at everyone but itself, the more the politicians and regulators will pass laws and rules like what we haven’t seen since the 1970s which gave us RESPA, TILA, ECOA and FCRA.

There is no doubt in my mind that the mortgage lending industry will find creative ways of compensating those that can bring the business in the door. 

Here is an idea:  Why not pay loan originators by the hour?  Consumers can pay their loan originator the way we pay for an accountant, a lawyer, an engineer, a paralegal, and other traditional professionals. 

In the above example of a $350,000 loan with a 1.75% loan origination fee of $6125, if we estimate that the average number of hours spent with the loan originator was 5 hours, that’s like paying an originator $1225 per hour.  There is no LO on this planet worth over a thousand dollars an hour.  But this isn’t an accurate figure if indeed the $6125 fee is split 50/50 with the originator’s company  So $3063 would be the originator’s compensation….divided by 5 hours means this LO is charging $613 per hour.

That’s a VERY hefty hourly fee for a person who doesn’t even have to hold a high school diploma to become a loan originator.  In fact I have personally now met 5 people who have only finished 8th grade that are originating mortgage loans.  Even a 20 hour education requirement and a national exam will not keep predatory lenders away from the industry.

Charging by the hour for an LOs time would serve two purposes:  1) it would motivate people to be more efficient with their time when working with a loan originator; and, 2) it would separate the men from the boys and the women from the girls. By this I mean loan originators with over 25 years of experience would be worth more because of their vast amount of knowledge: These LOs would theoretically be more efficient and competent and since they’d spend less time per file, they would be worth more. On the other hand, a baby loan originator who just received the license is going to be in training mode for a while and would arguably be worth less per hour.

Imagine an LO saying to his or her client, “Mr. AR, based on our initial consult, I estimate that it will take me and my team X number of hours to originate your file. It could be more or less, I’ll give you a weekly or monthly fee sheet as we go along. You can pay me by the hour…my hourly fee is X, or you can pay me no more than 3% total. Which would you prefer? It might be less if you select the hourly rate but it will never be more than 3%.”  I will bet you 100% of the time the client chooses the hourly rate for the chance that their fee might be lower in the end. 

But will things change all that much if LOs were paid by the hour? Maybe not.  The baby LOs will still end up working for the depository banks and the experienced pros will still end up at the non-depository mortgage banks and mortgage brokerage firms. When the Dodd-Frank Bill passes, our lives will all change once again but it’s still a great way of making a living and I know the majority of us will still be here doing just that.