Yield Spread Premium

A yield spread premium (YSP) is the money or rebate paid to a mortgage broker for giving a borrower a higher interest rate on a loan in exchange for lower up front costs, generally paid in Origination fees, Broker fees or Discount Points. This “may wipe out or offset other loan costs, like Loan Level Pricing Adjustments (instituted by FNMA).”

The YSP is derived through the realization of a market 'price' for a loan that is above 100%. For example, a $300,000 loan with a price when sold of 101.00% would 'yield' a 1% rebate to the originator. It is important to understand that the term 'originator' refers to either a retail bank or mortgage broker. The characteristics of a loan contribute to the price offered, such as the interest rate attached, the credit score of the borrower, purchase money versus a cash-out refinance, or a streamline refinance (which lowers the price because it is typically not accompanied by a property appraisal). Higher credit scores may add 0.25% to the price, while a lower one may cost up to 3.00% - which requires the borrower to either pay a discount fee to cover the loss to the lender when the mortgage is sold, or increasing the interest rate to absorb the risk for the mortgage security investor.

Update 11/25/2008 - Yield Spread Premiums are most commonly used by the Government Sponsored Enterprises (Fannie Mae and Freddie Mac) as well as the FHA and VA loan programs to 'steer' borrowers into specific tranches of interest rate most advantageous to the marketplace through specific cash incentives to the mortgage originator. A new phenomenon has developed since the mortgage crisis of 2008 in which more compensation is paid to the mortgage brokers for 'targeted' interest rates. For example, the Yield Spread Premium on a 30 year fixed rate of 5.50% might be 1.7%, while the YSP for 5.625% on the same loan may be 0.625%, and 5.25% might cost the borrower 1%. There is no longer necessarily a direct 'linkage' between yield spread premium and interest rate offered to the borrower when obtaining conforming loan products and government program loans.

The argument can also be made that yield spread premiums are used as an incentive to originate specific programs over others that are usually less desirable for the borrower. For example, a 30 year fixed rate mortgage generally pays a much higher yield spread premium to the broker than an adjustable rate mortgage.

In the U.S., mortgage brokers are required per the truth in lending act to disclose YSP within three days of the borrower's initial application on the Good Faith Estimate of Closing Costs, and then again as YSP as a fee "POC" (Paid Outside Closing) on page 2 of the HUD-1 Settlement Statement, inside the margin, away from the column marked "Paid from Borrower's funds at Settlement." This is a source of controversy, as similarly priced loans from banks require none of this disclosure.

YSPs as a financial instrument are controversial. What is controversial is the fact that brokers and lenders have different disclosure requirements regarding their existence.

In many local markets, the consumers may be repulsed by a 1.5% origination fee, generally regarded as the compensation an average or large sized brokerage needs to profitably operate, while in other markets that may be perfectly acceptable - depending on the level of local competition. In areas where "upfront fees" are less acceptable, the YSP tool is the only way a small business competing against the banks can operate.

Consumer groups such as the Center for Responsible Lending contend that disclosing the YSP to borrowers informs borrowers that the broker might be charging them a higher interest rate than they might otherwise qualify for. They either fail to realize or they simply omit the fact that banks engage in the identical practice, however are immune to same disclosure requirements. They point out that the YSP is a fee paid to the broker, and therefore its exact amount should be made known when the borrower commits to a broker ("locks in the rate"), rather than later in the loan process. In Florida, for example, this is already the law, and Florida mortgage brokers must disclose the exact yield spread premium up front. All lender paid compensation (YSP) to the broker must (a) initially be disclosed as a maximum (or exact) dollar amount to be received by licensee at closing and (b) re-disclosed at least 3 business days prior to closing the EXACT amount of YSP to be collected by the broker at closing.

Many reputable brokers offer the borrowers a range of rates and fees. They remove themselves from the adversarial nature by ensuring their compensation is approximately equal in all steps of the range, and it is up to the consumer to decide between "pay now" or "pay later".

There are many circumstances where most or all of the compensation to a broker may be best paid through YSP. For example, if the borrower is anticipating the sale of the property within a relatively short period of time, they are most likely better off financially to conserve their cash reserves and pay little or no up front fees, while paying a higher monthly payment for say the 6 month time they own the property. The payment may be $20, $60 or $120 higher, but would save thousands in acquisition cost that cannot be recouped.

Yield Spread Premiums are not a "given" for a broker. Many more responsible and experienced brokers will intentionally price with a rebate that is either realized as an incentive for an efficient closing, or if the transaction becomes stressed, will usually lose it to lender extension fees or pay for exceptions to the loan file that would otherwise incur a denial. Furthermore, most lending agreements with brokers restrict Early Pay Off (EPO) of the mortgage loan. For example, if the borrower refinances or sells the property within the EPO time period, usually 60 to 120 days, the lender contractually can and usually will demand reimbursement of the yield spread premium paid, while the broker has no recourse toward the borrower.

There is no "set" par rate, and there is a great deal of competition in the marketplace. Many lenders will only offer products to reputable brokers, and may pay those brokers more for their client loans, which are deemed higher quality in nature. In contrast, the brokers with a more checkered past may find themselves locked out from premium wholesalers and not have access to the best interest rates, products, or prices for loans. For this reason, the YSP is not a useful tool for comparing offers for financing from several different brokers. If broker A is anticipating a yield spread premium of 2% for a rate of 6.00% on a 30 year fixed, while broker B is anticipating a 1% yield spread premium for the same rate and terms, there is nothing in the disclosure to differentiate which would be more advantageous to the buyer. If anything, it may be assumed that broker A has either a better-run business, or has access to higher quality products than broker B. All lenders investigate their prospective broker partners, and the mortgage industry uses a watchdog group known as the Mortgage Asset Recovery Institute (MARI). Brokers with significant defaults, previous fraudulent acts, or shady loan officers will find themselves quickly on the MARI list and lose access to the most competitive offerings.

Other more skilled brokerages with access and the ability to locally underwrite or significantly complete mortgage files will also earn a higher compensation level from lenders that are much more automated in nature. Many brokers that lack internal processing expertise will be limited to lenders more willing to "work with" the less-prepared applications, and thus internally retain more of the anticipated compensation for the loan, rather than offer a portion of it to the broker.

Mortgage brokers contend that this disclosure requirement puts them at a disadvantage when compared to Institutional ("Retail") Lenders, who do not have to disclose their YSP. In addition, they point out that there are truly legitimate reasons for a YSP, such as help in offsetting closing costs for borrowers who are short of cash. For those borrowers, brokers use the YSP to help pay closing costs, as outlined below. Mortgage brokers also point out that since they are required to disclose their YSP and retail lenders are not, borrowers might not save money, but simply be steered to retail lenders who would charge the same amount or more for a loan, but would appear better at first glance because they did not have to list those fees explicitly.

Neither lenders nor brokers are in business to be a consumer advocate and non-profit companies are not allowed to offer mortgages unless relying on a for-profit entity operating in the marketplace. A broker that earns a higher compensation for the same task and the same product can often be seen as managing a more efficient business enterprise while remaining competitive in the marketplace.

In either event, within the United States mortgage system, virtually all loans are sold into the securities markets, and the cost of operating a financial business is real. The political climate of the United States is such that it encourages the continuous expansion of home ownership opportunity, and the most efficient way to do that is through direct lending in the neighborhoods, person to person. In this capacity, the brokerage community exceeds beyond all others, and originates the vast majority of the home loans in the United States without predetermined minimum lending criteria or standards as in a retail banking environment. For this reason, mortgage brokers will tend to spend much more time securing or attempting to secure financing for borrowers for which there will not be any compensation in the event they do not succeed and many times will cause a loss to the business. Retail banks avoid this possibility through other forms of revenue from the same potential borrowers they turn down through the offering of other services and associated fees.

These arguments are further outlined below.