Academic journal article Financial Services Review

Your Mortgage Loan: Fairly Priced, ... or Not?

Academic journal article Financial Services Review

Your Mortgage Loan: Fairly Priced, ... or Not?

Article excerpt

Abstract

Comparing the loan products of different lenders may well be the most difficult part of buying a home. Although time and resources spent comparison shopping may save hundreds, even thousands of dollars, comparing one loan to another isn't as easy as just comparing contract interest rates; borrowers must shop interest rates, points (both discount and premiums), and fees. Unfortunately, the process is complicated by inadequate regulatory disclosures, inconsistencies among lenders, and legal loopholes ripe for abuse. We present a simple four-step procedure that borrowers or financial planners can utilize to accurately compare loan products. We document many of the abuses borrowers must be wary of, in particular, the widespread misuse of the yield spread premium, and show how our process prevails, to the borrower's benefit. Our process should be of interest to both academics teaching real estate, as well as practitioners counseling their clients. © 2008 Academy of Financial Services. All rights reserved.

JEL classification: G21; K23

Keywords: Mortgage loan; Settlement costs; Yield spread premium; Discount points

1. Introduction

Home ownership is invariably one of the largest and most important investments made by consumers. Alongside the difficult choice of choosing a home and negotiating its purchase price is a myriad of complicated decisions associated with financing the transaction. This process is seldom a one-time event. Most individuals move, requiring new financing, or refinance when market conditions warrant. Unfortunately, the entire process, from selecting a lender to signing closing documents, is an extremely complex task ill-understood by many consumers. We posit three reasons for this lack of understanding.

First, the mortgage loan landscape has changed dramatically over the past 25 years. Historically, consumers obtained mortgage money from regional banks and thrifts that acted as intermediaries between their depositors and borrowers. Fluctuations in the supply of mortgage money caused by the inflow and outflow of deposits prompted the federal government to form agencies such as the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). By selling securities in the capital markets and using the proceeds to purchase pools of mortgage loans from financial intermediaries, these institutions act as conduits that link borrowers to the capital markets. The new lending environment, characterized by a separation of the mortgage loan functions, gave rise to a number of industry participants and loan products that did not historically exist. For example, mortgage brokers, largely absent before 1980, originated around 65% of the $2 trillion residential loan market in 2001 that are funded, held, and traded by investors in the form of mortgage-backed securities (Olson, 2002).

Second, the regulatory structure that surrounds and protects the mortgage transaction has failed to adequately evolve alongside the new lending environment (de la Torre & McClatchey, 2006). Of particular relevance are inadequacies in disclosures required by the Truth in Lending Act (TILA; P.L. 90-321; 15 USC §1601) and the Real Estate Settlement Procedures Act (RESPA; P.L. 93-533; 12 USC §2601). TILA was designed to protect consumers in credit transactions by requiring clear disclosure of key terms of the lending arrangement and all costs. Five items in particular are deemed so important that failure to give any one of them provides the borrower the right to rescind the transaction when a home is pledged as security. These are: the finance charge, annual percentage rate (APR), amount financed, total of payments, and schedule of payments. Borrowers frequently use the APR as a comparison metric in the loan selection phase; unfortunately, the disclosure falls far short of its intended purpose (McClatchey & de la Torre, 2006).

RESPA was enacted to help consumers become better shoppers for settlement services by eliminating kickbacks and referral fees and by requiring certain disclosures be given at various points in the transaction. …

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