(This is Part 2 of a two-part series. See Part 1: Real estate loan overcharges run rampant.)

Last week I explained why overpricing is so prevalent in the home mortgage market. While the inside prices posted every day by lenders for their loan officers and mortgage brokers (collectively “LOs”) are very competitive, overpricing often occurs at the point of sale where LOs confront borrowers. This is where the market degenerates into a mortgage bazaar. The LOs have a financial incentive to charge as much as they can, and they know the competitive inside price of each deal, which the borrower usually does not.

This may appear counterintuitive because LOs compete vigorously for clients. Doesn’t this competition drive down the price?

In some cases it does. I found that in a sample of upper-scale borrowers, who likely are more sophisticated than most, about 15 percent paid less than the inside price. The LOs in these cases had to share the shortfalls with their employers. But in 67 percent of the cases, the borrower paid more than the inside price. Competition at the point of sale is largely about which LOs borrowers select to overcharge them.

Is the mortgage bazaar discriminatory in the sense that some categories of borrowers are treated worse than others? Indeed it is. The bazaar discriminates against the gullible who believe that the price quoted to them is engraved in stone instead of being a whiff of smoke. It discriminates against the trusting who believe that the LO is serving the borrower’s interest instead of its own. But most of all, it discriminates against the passive who allow themselves to be solicited.

Consumers who find their LO by responding to solicitations pay the largest spreads over the inside price. They have to pay the costs of the solicitation, and they are least likely to understand the mortgage they are getting and the full terms of their deal. Soliciting LOs are prone to making outlandish claims as a way of hooking consumers who had not even been thinking about refinancing their mortgages. The best LOs live on referrals. They don’t have to spend time and money to acquire clients, and they don’t have to lie to them.

Does the mortgage bazaar discriminate against minorities? Inside pricing clearly does not. It is based on factors associated with risk of loss to the lender, including credit score, type of property, size of down payment, type of documentation and many other such factors. Race is never used in price setting.

In the mortgage bazaar, on the other hand, it would not surprise me if black borrowers had higher markups than white borrowers. Neither would it surprise me if they didn’t. Most LOs are equal-opportunity overchargers, meaning that they try to make as much as they can on every deal, whether the borrower is white or black. It is possible that, because of differences in cultures, they are more successful at this with blacks than with whites, but we don’t know. There are no data on markups classified by race.

[Parenthetical note: Data reported by lenders under the Home Mortgage Disclosure Act, which do show black borrowers paying higher prices, reflect both inside pricing and the mortgage bazaar. This makes them irrelevant to the question of whether black borrowers are discriminated against.]

How can borrowers deal with the mortgage bazaar? One approach is to master it, by learning enough to turn the tables on the LO. A number of pages on my Web site are devoted to this topic. Most mortgage borrowers, however, rather than trying to outwit the LO, prefer to avoid the bazaar.

One way to do this is to shop online among the better mortgage Web sites, which I identify on my Web site. There are no commission-incented LOs involved in online lending, only salaried employees who look to deliver loans at the prices posted on the sites.

A second way to avoid the bazaar is to retain a mortgage broker to act as your agent in finding a loan, paying the broker a set fee for the service. The broker passes through the wholesale price from the lender, so there is no haggling about the price of the mortgage. The borrower does have to negotiate the broker’s fee, but this much easier than negotiating the mortgage price. Brokers who operate this way, called Upfront Mortgage Brokers, are listed on my Web site.

By far the best approach to avoiding the mortgage bazaar is to provide the borrower with the inside price, and let the borrower select a lender or broker who will provide the mortgage at that price. This facility does not yet exist, but I’m working on it.

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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