(This is Part 2 of a four-part series. See Part 1: Real estate settlement services take bite out of borrowers; Part 3: Mortgage brokers struggle with consumer distrust and Part 4: Cost consolidation improves real estate loan shopping.)

The first article in this series indicated that third-party settlement services are overpriced because borrowers paid for them but lenders selected the service provider. Lenders generally use their referral power to benefit themselves rather than to drive down prices to borrowers. The remedy is to eliminate referral power through the adoption of a simple rule: Any third-party service required by lenders must be paid for by lenders.

This article is directed toward lender fees, sometimes referred to as junk fees. These are fees charged by lenders to cover specific lender costs. They are defined in dollars, as opposed to points, which are defined as a percent of the loan. Where points are one number, junk fees can be a whole bunch of numbers, each covering a specific charge.

The problem is that some retail lenders increase these fees after it is too late for the borrower to back out. Often, the borrower finds out about it at the closing table. It happens because of borrower inattention, industry locking practices, and terrible disclosure rules.

Borrower inattention: Borrowers are usually only dimly aware of lender fees. When they shop, their focus is mainly on interest rate and points, which are all that appear in media ads. The borrower’s first exposure to lender fees is likely to be when they receive a Good Faith Estimate of Settlement (GFE), but this typically doesn’t happen until after an application has been submitted. At that point, the borrower will be at least partially committed.

Industry locking practice: The mortgage market is highly volatile, with prices changing from day to day and sometimes within the day. Hence, rate/point quotes are not binding until the lender locks them. Lender fees, in contrast, are not volatile, and therefore the practice is not to include them in locks. The presumption is that at closing, they will be exactly what they were when the borrower received the GFE, and with honest lenders, they will be. But with dishonest lenders, the practice of excluding fees from the lock provides an opportunity to cheat.

The Good Faith Estimate: The GFE makes it all too easy for the cheaters. Lenders are not bound by any of the numbers on the GFE, which are “estimates.” This is ridiculous, since lenders know their own charges. In addition, the GFE confuses borrowers by showing each individual lender fee but no total, when the total is all that really matters. If the GFE were deliberately designed to take the borrower’s eye off the ball, it couldn’t have been done better.

Mortgage brokers provide protection: Excessive junk fees generally are not a problem on loans that go through mortgage brokers. Brokers know the fees charged by all the lenders with whom they do business, and they would not accept fee surprises at the closing table that put no money in the broker’s pocket. Broker fees are another matter, to be discussed in article 3 of this series.

Home purchases are most vulnerable: Excessive junk fees are more likely to arise on a home purchase transaction than on a refinance. On a home purchase, a buyer cannot walk away from the mortgage without walking away from the house. On a refinance, in contrast, a borrower can usually begin anew at any point without much loss.

Eliminating junk-fee escalation: In article 4 of this series, I propose a mandatory fixed-dollar fee on all mortgage transactions. The fee would cover all lender and third-party charges. Among other benefits, this would eliminate fee escalation at the closing table. Fee escalation could also be eliminated by a rule stipulating that when lenders lock the rate and points, they also lock their fees.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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