The following is a discussion of these prohibitions and examples of transactions in which these prohibitions are a compliance issue for loan originators.
The prohibition against compensation based on the terms and conditions of the loan is intended to prevent loan originators from receiving compensation based on factors such as:
- Interest rate
- Annual percentage rate
- Loan-to-value ratio
- The inclusion of a prepayment penalty
It is important to note that this prohibition applies to all transactions, and is not limited to those in which an originator knowingly imposes more onerous lending terms, such as a higher interest rate for the sole purpose of earning a better commission. The Rule provides the following example to illustrate the broad application of the prohibition:
…assume that Consumer A and Consumer B receive loans from the same loan originator and the same creditor. Consumer A has a credit score of 650, and Consumer B has a credit score of 800. Consumer A’s loan has a 7% interest rate, and Consumer B’s loan has a 6.50% interest rate because of the consumers’ different credit scores. If the creditor pays the loan originator $1,500 in compensation for Consumer A’s loan and $1,000 in compensation for Consumer B’s loan because the creditor varies compensation payments in whole or in part with a consumer’s credit score, the originator’s compensation would be based on the transactions’ terms and conditions. (12 C.F.R. Section 226.36 (d)(1)(2)))
In order to fully understand the types of compensation practices that are prohibited, it helps to understand permissible compensation practices. Loan originator compensation cannot be based on the terms and conditions of a loan, but it “…may be based on the amount of the credit extended.” (12 C.F.R. Section 226.36 (d)(1)(9)))
However, it is important to note that while creditors may compute the amount that they compensate a loan originator as a percentage of the amount of credit extended, the percentage cannot vary from one transaction to the next. For example, a creditor may agree to pay a loan originator 1% of the amount of credit extended in all transactions, but cannot agree to pay 1% in all transactions up to $500,000 and 1.50% in transactions that exceed $500,000.
When compensation from a creditor to a loan originator is based on a percentage of the credit extended, the compensation “…may be subject to a minimum and/or maximum dollar amount, as long as the minimum and maximum dollar amounts do not vary with each credit transaction.” (12 C.F.R. Section 226.36 (d)(1)(9))) The Rule provides the following example of this type of compensation arrangement: “A creditor may offer a loan originator 1% of the amount of credit extended for all loans the originator arranges for the creditor, but not less than $1,000 or more than $5,000 for each loan.” (12 C.F.R. Section 226.36 (d)(1)(9.i)))
In addition to computing compensation on the basis of the amount of credit extended, the Rule states that each of the following compensation methods is acceptable. Creditors can determine how much to compensate loan originators based on:
- Loan volume, calculated by determining the total dollar amount of credit extended or the total number of loans originated
- Long-term performance of the loans negotiated by the loan originator
- Hourly rate, calculated by determining the actual number of hours the originator works
- Success in bringing new customers to the creditor
- A payment schedule arranged in advance, such as $1,000 per loan for the first 1,000 loans originated and $500 for each additional loan
- The percentage of loan applications that result in consummated transactions
- The quality of the loan originator’s loan files, such as “…the accuracy and completeness of the loan documentation”
- Business expenses involved in loan origination
(12 C.F.R. Section 226.36 (d)(1)(3. i-viii)))
Based on considerations, such as those listed above, a creditor can make periodic revisions of the amount that it pays a loan originator. An example of acceptable periodic revisions to a compensation plan is that of a creditor who decides to increase a loan originator’s payment for each loan delivered after the originator shows that he/she can consistently deliver a high volume of loans to the creditor. (12 C.F.R. Section 226.36 (d)(1)(6)))
As noted in the introduction, the origination of a loan with an interest rate that is higher than the rate for which a borrower qualifies is a tool that can help a borrower who does not have the cash to pay the costs associated with obtaining a loan. In its Official Staff Interpretations, the Board clarifies that the Rule “…does not limit a creditor’s ability to offer a higher interest rate in a transaction as a means for the consumer to finance the payment of the loan originator’s compensation or other costs that the consumer would otherwise be required to pay directly….” (12 C.F.R. Section 226.36 (d)(1)(4))) The Board provides the following example:
…if the consumer pays half of the transaction costs directly, a creditor may charge an interest rate of 6%, but if the consumer pays none of the transaction’s costs directly, a creditor may charge an interest rate of 6.50%. (12 C.F.R. Section 226.36 (d)(1)(4)))
The Official Staff Interpretations also clarify that the rules are not intended to prevent a creditor from charging a higher rate of interest based on the risks associated with the transaction. For example, if a borrower has a poor credit history, a high debt-to-income ratio, and/or a high loan-to-value ratio, the creditor can charge a higher rate of interest.
The Rule no longer allows loan originators to receive direct compensation from borrowers and additional indirect compensation from the creditor that funds mortgage loans. As the Board states: “…if any loan originator receives compensation directly from a consumer in a transaction, no other person may provide compensation to a loan originator, directly or indirectly, in connection with that particular credit transaction….” (12 C.F.R. Section 226.36 (d)(2)(1)))
Prohibition Against Double Compensation
In its Official Staff Commentary, the Board clarifies that this prohibition on double compensation applies only to commissions, such as YSP, that creditors pay after loan originators have already obtained direct compensation from a borrower. The prohibition does not apply to salaries or to hourly wages that are not paid to a loan originator in connection with a particular transaction. For example, if a mortgage broker pays its employees a regular salary that does not vary based on the terms and conditions of each mortgage loan transaction, these loan originator/employees may receive direct compensation from borrowers.
If John charges a broker fee of $2,500, and the Smiths’ use the yield spread premium to pay their closing costs, is John in violation of the Federal Reserve Rule?
No. The Federal Reserve Rule prohibits “Double Compensation.” This means the broker may not be paid directly by the borrower, as well as indirectly by the lender. The prohibition applies specifically to compensation, so the Smiths’ using the YSP to subsidize closing costs is allowable.
Prohibition Against Steering
In its Official Staff Commentary, the Board describes steering as “…advising, counseling, or otherwise influencing a consumer to accept…” a particular credit transaction. (12 C.F.R. Section 2226.36 (e)(1)(1))) Steering is prohibited when it is done for the sole purpose of increasing the loan originator’s compensation. Since consumers actually look to loan originators for direction when it comes to choosing a mortgage product, the Rule creates a “safe harbor,” defining those circumstances in which the guidance offered by loan originators does not constitute illegal steering.
The first issue that loan originators must address in seeking to establish a safe harbor is the number of loan options that they must offer. The Rule does not establish a set number of loan options that a loan originator must provide, however it does include provisions that are intended to ensure that loan originators provide consumers with viable options. First, the Rule provides that for each type of mortgage product in which the borrower expresses an interest, the loan originator must provide options that include:
- The lowest interest rate for which the borrower qualifies
- The loan with the lowest interest rate that does not include any of the following:
- Terms that permit negative amortization
- Prepayment penalties
- Interest-only payments
- Balloon payments in the first seven years of the loan term
- A demand clause
- Shared equity
- Shared appreciation
- The loan with the lowest total dollar amount for origination points, or fees and discount points
The loan originator cannot present any loan options to the borrower without “…a good faith belief that the options presented to the consumer…are loans for which the consumer likely qualifies.” (12 C.F.R. Section 226.36 (e)(3)(C)(ii)))) This “good faith belief” may be based on information provided by the loan applicant to the loan originator “…even if it subsequently is determined to be inaccurate.” (12 C.F.R. Section 226.36 (e)(3)(4)))
For example, a loan originator can initially suggest mortgage products based on a borrower’s representation of his/her debt-to-income ratio. If the ratio proves to be higher than represented, the loan originator cannot be deemed to have failed to make recommendations based on a good faith belief that the borrower will qualify for them.
Another factor that is relevant in showing that the loan originator has provided a significant number of loan options is the number of creditors that a loan originator approaches in order to find a mortgage product that will meet the needs of a loan applicant. The Rule does not require loan originators to approach a particular number of creditors, and only requires that originators contact those creditors “…with which the originator regularly does business.” (12 C.F.R. Section 226.36 (e)(1)(2.i)))
The Official Staff Commentary provides guidance on determining which creditors are those with whom the loan originator “regularly does business.” These are the creditors that:
- Have a written agreement with the loan originator for the submission of loan applications
- Have funded a mortgage loan for one of the loan originator’s clients during the current or previous calendar month
- Have extended credit 25 or more times during the previous 12 months, funding loans submitted by the loan originator
(12 C.F.R. Section 226.36 (e)(3)(2. I-iii)))
Although loan originators are required to obtain a number of loan options from a number of creditors with whom they regularly conduct business, they are not required to present every loan option to their clients. The Official Staff Commentary provides the example of a loan originator who has obtained three loans from one of the creditors with whom the loan originator does business.
If each of these loans is a type of mortgage product in which the borrower has expressed an interest, and offers the lowest interest for which the borrower qualifies without onerous terms such as negative amortization and prepayment penalties, and the lowest total dollar amount for origination points or fees and discount points, the loan originator is not required to offer options from any other creditor. (12 C.F.R. Section 226.36 (e)(3)(1)))