In order to understand how no closing cost home equity loans work it is important to understand the financial mechanisms that contribute to the cost for these types of loans. Mortgage brokers often use Yield Spread Premiums (YSP) in order to be able to provide no closing cost loans. The way that it works is as follows; a borrower decides to take out a $600,000 loan. Based on this loan, the closing cost would be calculated to be $4,000 of additional payment at the end of the loan.
The borrower then accepts the offer and signs for the loan. Now the YSP can actually increase the interest rate that pays the broker as the broker received the monthly installments from the borrower. In the given example it may be the case that the broker is able to earn an additional $6,000 of interest on the loan. Then they can give the borrower $4,000 to close the loan at no additional cost to the borrower, while making a tidy $2,000 profit for himself or herself.
When would a borrower know that YSPs are being used?
Whenever a home loan is offered with the banner “no fee” or “no closing cost” you can work out that YSP is at work. It is impossible for a broker to offer a loan with no cost and stay in business, because they will not be able to make any profit. The YSP allows the broker to charge the borrower at a rate that will pay enough YSP interest to cover the costs of closing the loan on the due date and at the same time making an additional profit for their brokerage business.
It is important to take note that this is a very conditional assumption, that the broker would share the benefits of the YSP with the borrower. The reason this is a conditional statement is because the broker is under no legal obligation to share the information with the borrower. The HUD rules, HUD-1 to be exact, explain that the broker needs to declare the YSPs it holds to the financial institutions, but not to borrowers.
What sort of interest rates might you pay with no closing cost home equity loans?
A broker will typically urge you to move to a slightly higher interest rate mortgage to benefit from no closing cost home equity loans. Should you accept, the broker could receive an YSP of about 1.5% more than they would have received from borrowing from traditional sources. As in the example above the broker could receive $10,000 of extra interest, pay $4,000 to the borrower to satisfy the no closing cost clause and will have $6,000 of profit rather than the $2,000 by encouraging and convincing the borrower to take a higher interest rate home loan. HUD-1 differs from the documents handled by an escrow company, and in particular escrow companies who specialize in loans.
Escrow loan companies usually use good faith estimates. The broker can provide details of these and the way they work is to be considered as a pre-contract agreement for interest rates that will eventually be charged. While arguably these are no more than estimates until the loan is ready to be funded this form of estimate, known as an est. HUD is legally binding and cannot be altered after the loan is put into place. There is one exception, if the borrower re-signs any documents that disclose certain financial charges that are associated with the loan, it is often known as “re-disclosure” documentation.
What happened in the past?
Between 1998 and 2005 during the period known as the refinancing boom a number of rogue mortgage brokers took advantage of YSPs to defraud wholesale lenders on a massive scale. These mortgage brokers collaborating with borrowers practiced a sting that worked in the following way. First the borrower would accept a loan at a much higher interest rate than normal, this in turn would cause the YSP payout to be far higher than normal, and that would then be paid to the broker. Using the earlier example a loan of $600,000 with a 3-point premium would generate an extra return of $20,000 instead of the expected $6,000 as the borrower had accepted a higher overall loan interest rate on their loan. Broker and borrower would share the spoils of the YSP loan and the wholesale lenders would lose out. This practice is known as churning and has been indicated by many experts as the initial cause of the later recession.