Why Do Mortgage Brokers Get Paid Everything Up Front?

Blog reader Chris Harris raises an interesting question in an email to us: Why do mortgage brokers get paid everything up front when they originate a deal?

This sort of contract gives brokers terrible incentives. They just want to get a deal done. It matters very little to them whether the borrower eventually defaults or not. (It is possible that if their clients always go into foreclosure, then the lenders with whom they work will steer clear of them; but since most loans are sold off by the originating banks anyway, this mechanism is likely to be a very weak form of discipline.) We’ve written in the past about my student Zahi (Itzhak) Ben-David‘s work on real estate fraud and the role that mortgage brokers played.

Chris Harris offers a simple solution to the problem: instead of paying mortgage brokers a lump sum when the deal closes, have them pay a small amount out of every mortgage payment. That way, the mortgage brokers will have a disincentive to initiate high-risk mortgages that are likely to default.

One has to be a little careful with this sort of solution, however, because if you pay the mortgage brokers a percentage of the mortgage payment, they will have an incentive to make the mortgage payment as high as possible, which is definitely not a good idea.

A simple alternative is to make the mortgage broker’s monthly payment a fixed percentage of the value of the loan. This isn’t perfect either, but it might be a step in the right direction.


Dave T

It's my point of view, as a mortgage broker, that the wholesale lender issuing the approval is responsible for the borrowers ability to repay the loan. Thats what the underwriting process is for. Remember that, as a broker, I merely ADHERE to underwriting guidelines established by the banks and do not create them. I research the programs available, offer options to my clients if available and assist the with compiling the necessary paperwork for an approval(much more difficult than I describe!). The banks underwriter will respond to me with:
1) an approval
2) a conditional approval where additional documentation is required
3) or they can turn the loan down.

As far as my compensation is concerned, since I have performed the required steps to obtain a loan approval, at that point in time, my responsibility should end and my compensation should arrive in full either at closing or the fourth day after in the case of a refinance(There is a 3 day right of rescission in NJ for refinances).

Any default(s) should result in a review of THEIR underwriting guidelines, and changes to THEIR guidelines should occur if and when an unwanted trend appears.

It's really quite simple and doesn't need to be more complicated.

DT

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Mr. Tim

Please if someone from Australia needs loan from UK does he has to pay for any kind of up front fees and if the loan is up to $300,000 how much will he be required to pay as up front that will cover the whole expense. i need an ugernt response before i make mistake. Thanks

alan

As a mortgage banker I have long been in favor of switching to residuals. Other than the positives you mention it would have the added benefit of stopping loan flipping and they would have no benefit replacing a old income stream with a new one rather than being paid two up fron comissions, and a less tangible psychologically benefit of making mortgage people think long term rather than short term.

As for the disdvantage you mentioned well there is a incentive for mortgage lenders to sell you you a higer rate and in essence raise the payment so that effect would be minimal. However I am sure a factor of loan performanse and loan size could just as easily be substituted.

Stephen

Probably been said, but to me the fundamental problem seems to be ratings, i.e. The loan packages containing high-risk loans where rated as very sound. This should never have been the case. If they were accurately rated, the price would have been discounted for possible defaults when the loans were bought, and no-one would have to take write downs. Fix what is broken, and what is broken is the ratings system that allows loans of varying quality to be lumped together.

Alan Wu

Very interesting idea...
The core of the idea is to break up the payment and pay the broker over the life of the loan instead of all upfront. So just take the current amount of commission (however it's calculated) and divide it in a reasonable way over the life of the loan (figuring in the cost of loss of use of money).
If the borrower refinances or pays back the loan, then the broker would get the remaining balance of the commission. This might seem like an opportunity for the broker to collude with the borrower to refinance and get the fee, but there is the same incentive in the current system when the broker is paid upfront, so there is no difference in that regard.

Linda Palmer

The easiest fix is to initiate National Licensing so that every Mortgage Broker and Banker begins service knowing something more than passing a State test where they exist. Many States don't even require a test of any type. An Apprentice program might also be initiated so a Loan Originator works under an Administrative Broker for a period of time.

Suggesting a long term pay out for Brokers won't work. As rates change, consumers will seek better pricing and new loans. The Mortgage Broker in the business for the long haul doesn't put their clients into risky loans their clients can't pay back as they see their clients as 'ongoing' customers over many transactions throughout many years of selling and buying real estate.

Experienced Mortgage Brokers also seek out Lenders with the best rates and terms for their customers under the guidelines they are given by the direct Lenders. They are the best hope for borrowers in the market place.

Can you imagine a marketplace with only a handful of powerful global interests making all the loans?

There is a huge attempt today to blame the Mortgage Broker for the crisis we all face today. It is like blaming the reservation clerk for an airplane crash. Convenient, but way too simple.

We can, and should, clean out the trash...and national licensing seems to be the best bet. As for those who made loans knowing people could not pay on the interest rate 'resets'...enforce the laws currently on the books and the rest will get the message loud and clear.

When Mortgage Brokers get paid, they get paid well...but for every loan that closes today...their are dozens that will never get funded. Mortgage Brokers don't get paid for loans that don't close. That's why they call it 'commission'. It is also extremely unfair that only Mortgage Brokers must disclose the amount of money they are making on a transaction.

Banks, Credit Unions, Insurance Agents and Financial Planners have no such requirement. Perhaps the current 'opinions' about Mortgage Brokers exists because they have virtually no 'Lobby Clout' as does their esteemed competitors.

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Tony

Brokering a mortgage is not like brokering stock. The market for a mortgage by no means transparent. Just try to research the best priced mortgage on the internet. The largest lenders and banks don't publish their street rates. If they did they likely wouldn't get any business and all the business would go to the some other lender with the better pricing. Also, sites like LendingTree certainly don't give you the best pricing in the marketplace. Most brokers therefore provide a valuable service.

That does not even to take into account the qualification differences between the 1000s of mortgage lenders out there. Borderline customers might have to apply to 10 different lenders before they found the right lender for their situation. Quality brokers are expert at sorting through the mess of guidelines and lender idiosyncracies to get the right loan to the right lender.

Mortgage brokers provide a valuable service and that is to bring fluidity to the marketplace.

That being said, if a law were passed to compensate brokers based on a soley with a small monthly payout there would be no brokers because it would take too long to acheive the critical mass to make a living. The Aussie model of the large up-front and small recurring sounds better but would but really just amounts to a rainy day plan for the broker when he has no business. In America, most lender have in place agreements with their brokers that they have to repay compensation when they prepay early. There are also whole loan repurchase agreements in the event of fraud. That seems like sufficient disincentive for the broker.

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R. Miller

You have forgotten one important component of the mortgage process - the banks which employ the services of these mortgage brokers were originating-to-sell. They siphoned off the fees and then passed off the risky, illiquid mortgages to anyone stupid enough to buy them. Fannie and Ginnie bought many of the risky assets, confident in their implicit government backstop which we now see was a rational expectation. The mortgages were packaged, securitized, and rated AAA in the belief that risks were diversified.

It was a feeding frenzy and everyone was either getting rich from it or expecting to get rich: mortgage brokers, lenders, investment bankers, realtors, retailers, GSE's, and flippers. No one with any power who saw this coming dared throw a wet blanket on the party.

The entire mortgage fiasco is a repeat performance of the 1990's and the 1980's where misguided government "homeownership policy", tax incentives, and deficient regulatory oversight allowed market abuse.

There's a carcass on the desert floor and you're blaming the ants for taking some bites. You're not blaming the vultures encircling it. And you're not blaming the desert heat for creating the carcass in the first place.

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MileHighDave

I've got a better idea. Why don't we just get the government involved in everybody else's job as well.(They are already on their way to costing taxpayers billions by sticking their nose into the mortgage mess)We can start with the Economists who won't get paid when their predictions are wrong. How about the weatherman who snows on my camping trip when the sun is supposed to shine?And let's not forget about the salesperson at the car dealership who should be held responsible for the oil leak on my new car. Geez, we can all just work for free!

Dave says Steven should look a little harder in his own back yard - Wall St - they are the greedy ones responsible for this article. They gave me the keys to the castle. I only opened the door. Here's an awesome link to what really happened:http://www.indypendent.org/2008/02/05/how-wall-street-killed-the-economy/
And what of the "Predatory Borrower"? Yes boys, they do exist.

Banks will never replace a good Broker. The Banks loan officer will never find a way to go to a client's home and go through a box of paper to find a pay stub the client is too lazy to find on their own. They will never answer the phone on a Sunday afternoon. They won't make an appointment at 9pm when a borrower gets off of work. They won't attend a closing 50 miles away. They won't answer their cell phone while on vacation for the Realtor who needs a Pre-approval letter. They won't go into the housing project to take the application of the customer who has no phone or no car. And they will certainly never, EVER give up their own pay should they make a mistake on a borrowers loan. Or eat the fee for an appraisal on a deal that won't close. And the last Acid test:I'm sure everyone has received a call from their "Bank" who shall remain nameless, wanting them to spend $1700 to refinance their loan in order to save $7...Yes do the math...240 months to make your $$ back..this has actually happened to me so I know I'm not alone.

Yes this is what a truly GOOD Broker does for their client - we build lasting relationships, acting as a "Trusted Advisor", and not just peddling the products of any one Bank. We remember their 1st names and the names of their kids when they call 4 years later for another loan. We call out of the blue just to say "Hi, how's the family"? We spend thousands of dollars of our own money every year for Education as well as the tools to do our job better.We invite clients into our own homes when we throw a party...and DAMMIT Steven we deserve to be paid!

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Winston

If you switch from paying the whole commission up front to paying it over 25 years, doesn't that mean you've cut the pay for the first year on the job as a mortgage broker to one twenty-fifth of what it was? And that it would take 25 years of the same amount of work before you'd get the type of annual income you'd get now?

John Berta

I find it curious that you singled out mtg brokers.
Real estate agents also get paid when the deal closes.
A mtg brokers job is to simply provide mtg's to clients, we know this, mtg brokers must abide by lending regulations given by financial institutions and or govt's.
A mtg broker is not concerned with whether or not a client is able to make these mtg payments or not, and anyone who thinks they are; is delusional.
If the client falls within the financial industry or govt's rules and regs and qualifies for the loan, there work is done.
Have you ever had a sales person of any kind ask if you can afford that item?
Place blame on those that make the policies, rules and regs not the ones who play by them.
My $.02,
Cheers!
-Jb

Jeff

Similar to what Mark Harrison said above, most mortgage brokers are subject to what they call recourse provisions, no? Meaning that if the payments become delinquent within, say 12 months after the loan is made, the broker must refund his/her commissions to the lender. I'm pretty sure that's the way it works.

You can say that the lenders should extend that provision to 24 or 36 months, but lenders compete with each other to buy loans as well, and in any case, I think there's a lot of things that banks would do differently if they had the last four years or so to do over.

CT reader

1. Brokers should be held to a fiduciary standard. They must put the interest of the client before their own.
2. Brokers should receive their commission over time. Perhaps over 5 years rather than over the life of the loan. Insurance companies pay their agents this way. If the client cancels the policy, the agent doesn't receive any additional commission. If this structure were implemented, there would be fewer prepaymet penalties to the borrower who refinances.
3. Many brokers put their clients in sub-prime loans when the clients could have qualified for a prime loan...higher costs for the borrower and bigger commissions for the broker.
4 If fiduciary standards for brokers were in place over the last few years, we wouldn't be in the economic environment we're in now.

SES GSB 1997

This would apply to then to almost any agent or broker transaction - should a broker who represents a client in a transaction vouch for the client's future actions? This could apply to lawyers, agents, or brokers (sports, movie, or even job placement firms). The duty to perform proper due diligence lies with the recipient not the broker.

For example a broker represents a tenant (i.e. Bennigans) to lease a 5,000 sf retail location for 10 years. The commission is paid upon tenant's initial occupancy and payment of the first months rent. The broker here acted as a conduit in procuring a tenant to the Landlord - it is the Landlord's responsibility to perform due diligence on the tenant (Bennigans) to ensure the tenant is not about to go into bankruptcy.

Kent

By basing a mortgage broker's pay on the borrower's repayment performance, you're unfairly asking him or her to assume the borrowing risk.

But that's the lender's role, not the mortgage broker's. The broker just helps make the connection between the two and helps expedite the process. He's quite possibly the most (but not totally) innocent middleman in this whole crisis, which was precipitated by selfish, ignorant borrowers and greedy lenders.

stuandgravy

As @20, here in Australia the standard arrangement lenders have with brokers is for an upfront fee (0.50%-0.70%) and then ongoing ('trailing') commissions (0.15%-0.35%). The trailing commissions are often deferred for one or more years, to provide further disincentives for the brokers to churn loans.

ZBicyclist

One area that might be ripe for deferred payment is professors at research universities. Let them get paid for how many of their grad students make tenure (weighted for quality of institution), and how many of their papers are even read at all 5 years after publication.

I will leave it to others to propose a system for undergraduate institutions, but the logic of a system is compelling.

If students are paying off their education for a decade after graduation, shouldn't professors get paid on the same schedule? Isn't that similar to Levitt's argument? ;)

Oz

As a broker and also an economist, I'd like to inform you that inasmuch as all this look pretty good on paper. It is hogwash. I'd loose all my sales people in 30 min if you suggested this. You'd kill the thrill of a deal. That is a factor you can never rule out. Sometimes the high of the payday is very addictive.

Punditus Maximus

Another reform -- fix "drive until you qualify." Commuting costs roughly equal the difference in housing prices, so include "distance to workplace" in the calculations for who can afford what.

AussiePete

This is exactly how Australian Mortgage brokers get paid.
An upfront lump sum (typically 0.7% of the total loan value) and then trailing commissions from each loan paytment.
Works fine, and we certainly have nothing like the default problems you guys have (1% default rates are seen as terrible here) despite having gone through our own housing boom a couple years ago.