The Consumer Financial Protection Bureau (CFPB) recently unveiled an internet-based tool designed to help consumers shop effectively for the lowest possible mortgage interest rate. For this tool to work, it must help mortgage shoppers distinguish between rate differences that are justified, which borrowers would have to pay in a perfect market no matter how effectively they shop; and rate differences that arise because lenders know more than borrowers and control the process, which might be overcome by effective shopping.
I have been examining the CFPB tool to see how well it meets this challenge, and will report on it next week. This article lays the groundwork by looking at the different sources of rate differences.
Justifiable Rate Differences
Some borrowers pay higher interest rates than others for reasons that have nothing to do with their knowledge or ability to shop. They would pay more even in a perfect market.
Transaction Timing Differences: The rate quoted to one borrower may differ from the rate quoted to another if the quotes apply to different times and the market changed within that period.
Mortgage lenders set their rates every morning after secondary markets have opened and they have checked the opening prices. The rates posted may last through the day, or they may not, depending on what happens in secondary markets during the day.
Shoppers can place no credence in price quotes that do not show the date and time to which they apply. Effective shopping requires access to price quotes that are time-stamped.
Lender Fee Differences: Mortgage lenders charge upfront fees, some defined as a percent of the loan amount, which are called "points", and others that are a fixed dollar amount. The rate difference between loans with the highest fees and those with negative fees (rebates) can be as large as 0.625%. A rate quote that does not also show the fees that go with it is meaningless.
Differences in Transaction Features: From a pricing perspective, each mortgage loan can be viewed as a collection of 9 transaction features that affect its price. In summary, the list of 9 is as follows:
State Location of Property: Loans in states with laws that make it more costly to foreclose on a mortgage will carry a higher price (rate and/or fees).
Occupancy Type: Loans on second homes or rental properties will be priced higher than loans secured by the borrower's primary residence.
Property Type: Loans secured by properties other than single-family detached homes will be priced higher than loans secured by single-family homes.
Loan Purpose: Refinance loans in which the borrower withdraws cash will be priced higher than loans to finance a home purchase or to refinance without taking cash out.
Loan Amount: Loans that are too large to sell to Fannie Mae or Freddie Mac will be priced higher than those that are below the maximum size limits of the agencies.
Down Payment: Loans with the smallest permissible ratio of down payment (or equity) to property value will be priced higher than loans with a larger down payment.
Credit Score: Loans with the lowest permissible credit score will be priced higher than loans with a higher credit score.
Lock Period: Loans on which the lender locks the price for more than 30 days will be priced higher than those with 30-day locks.
Waive Escrow: Some borrowers want to pay taxes and insurance themselves, rather than set up an escrow account from which the lender will make the payments. Such borrowers are said to "waive escrow," and they pay a higher price than those who accept escrow.
Unjustifiable Rate Differences
Interest rate differences associated with differences in the timing of transactions, in lender fees and in important transaction features are justifiable in the sense that they would exist even if markets were perfect. But this market is very far from perfect because of the complexity of mortgages, the complexity and length of the mortgage process, and the sizeable knowledge imbalance between lenders and borrowers. For these reasons, some borrowers pay more than others on what would otherwise by an identical transaction.
One of the worst of the market imperfections, made possible by the long processing period required to generate a mortgage, is the fake price quote. Since rate quotes do not commit a lender until they are locked, and the market is very likely to change before that happens, some lenders are tempted to "low-ball" -- meaning to quote a price they have no intention of delivering -- in order to be selected by the borrower. Once the borrower gets involved in the process, such lenders have no difficulty finding explanations for a price adjustment, and the cost to the applicant of disengaging and beginning anew somewhere else becomes increasingly high.
I spend a lot of time advising borrowers on how to avoid unjustified charges, and the new CFPB rate tool, which I will report on next week, is aimed at this problem.
For more information and unbiased mortgage advice, you can contact the professor at The Mortgage Professor.