Final Rule on Loan Originator Compensation

The debate over loan originator compensation began long before the mortgage lending market faced its most recent dilemma.  The particular compensation practice that has been vigorously contested for more than a decade is the payment, by lenders, of yield spread premiums to loan originators.

Yield spread premiums (YSP) are commissions that mortgage loan originators earn from lenders when a borrower accepts a mortgage loan with an interest rate that is higher than the par rate.  The primary argument against YSPs is that loan originators have no incentive to offer a qualified borrower a loan at the lowest interest rate available when they can earn additional compensation by steering the borrower towards a loan at a higher rate.

On September 24, 2010, the Board published its Final Rule in the Federal Register.  The Rule amends Regulation Z with the creation of special prohibitions and restrictions for the compensation of mortgage loan originators.  The stated purpose of the Rule is “…to protect consumers in the mortgage market from unfair or abusive lending practices that can arise from certain loan originator compensation practices….” [1]  In its Official Staff Commentary to the Final Rule, the Board noted that the payment of YSP results in:

• A lack of transparency related to the cost of a loan
• An irresolvable conflict of interest between loan originators and the borrowers that they represent

Federal lending laws such as TILA and the Real Estate Settlement Procedures Act (RESPA) were adopted to ensure that consumers understand the cost of credit and the costs associated with closing mortgage loans.  Although RESPA requires mortgage loan originators to disclose YSP on the Good Faith Estimate and the HUD-1 Settlement Statement, borrowers could potentially misunderstand this line item disclosure.

Many borrowers pay direct compensation to their mortgage broker or loan originator, believing “…that this amount is all the consumer will pay and the broker will receive.” [2]  Few realize that the originator may also receive additional payment in the form of YSP.  This lack of clarity regarding the cost of obtaining a loan defeats the goals that RESPA and TILA have set for making the costs of credit transparent.

Historically, YSP has benefited borrowers who do not have cash to cover the costs of settlement. They can accept a loan at a higher interest rate, using the additional fees that their mortgage loan originator earns from YSP to cover the costs of closing. The Department of Housing and Urban Development refers to this as a borrower credit. It is in the transactions where originators use YSP for the sole purpose of earning additional compensation that an ethical dilemma arises.

First, as noted above, borrowers often do not understand that their broker or loan originator is earning an additional fee in the form of YSP.  Secondly, borrowers “…often wrongly believe that brokers have agreed or are required to obtain the best interest rate available.” [3]  The Board found this misperception to be one of the most compelling reasons to adopt a rule that addresses the use of YSP as a tool for originator compensation.

It has been determined by law makers that loan originators who know that they can legally earn more income by steering borrowers towards high-interest loans are not likely to pair them with loans at the best-available rates.  If borrowers understood originators’ motives for steering them toward certain loans, they would shop more aggressively for favorable lending terms.  However, by entering these transactions under the assumption that an originator serves as their advocate, it has been found that borrowers rarely make an effort to shop around.

As the Board noted, consumers who believe that loan originators are “trusted advisors” or “hired experts” who are legally or ethically bound to find the best loans at the best rates “…are far less likely to shop or negotiate to assure themselves that they are being offered competitive mortgage terms.” [4]

Loan originators, consumers and regulators have been engaged in the debate over YSP for more than a decade.  The legality and ethical soundness of YSPs have been debated in court and in public hearings.  The two principal arguments against a ban on YSP have been the claims that:

• YSP is often used to help borrowers pay closing costs
• It is unfair to ban YSP for mortgage loan originators who are working for non-depository lenders when mortgage loan originatorsworking with traditional, depository lenders are allowed to earn similar compensation

The Final Rule shows that the Board gave due regard to these arguments.  As a result, the Board drafted a rule that is not an absolute prohibition on YSP.  The rule allows originators to continue to use YSP to help cash-poor borrowers who are struggling to meet closing costs.  The Board also wrote a rule that is broad in its scope, applying not only to originators employed by mortgage brokers, but also to those who work as mortgage loan originators for depository institutions.

Following is a review of the definitions and provisions of the Final Rule.  The text also contains examples of factual applications of the Rule’s prohibitions.  These examples are taken from the Board’s Official Staff Commentary.