One of the many unsavory features of the home loan market is that borrowers, when they close on their loans, sometimes find their settlement costs substantially higher than the earlier estimates given to them in the Good Faith Estimate of Settlement (GFE). Lenders are required by law to provide the GFE to borrowers within three days of receipt of a loan application, but the GFE is sometimes used in bad faith.

Some lenders as a matter of course raise their fees or add new ones as a loan moves toward closing. This is especially easy to do on purchase transactions when borrowers pass a point where there isn’t time to begin again with another loan provider. Some lenders low-ball third-party fees as an inducement to borrowers who believe they can shop total fees, then raise them at closing.

HUD tried to deal with this and many other problems a few years ago with a proposal that allowed lenders to package a mortgage and all related services, which would be offered to borrowers at a single price. The proposal was very complicated; different parts offended different groups; and, as a result, it died. Reportedly, HUD has since been working on a less ambitious agenda, but nothing has emerged as yet.

Meanwhile, the Mortgage Bankers Association (MBA), which is the major trade group of mortgage lenders, has come out with its own proposals, part of which are directed to GFE abuse. The entire proposal is contained on their Web site, www.mbaa.org.

The MBA proposes that deviations between the lender and mortgage broker charges contained in the GFE and those paid by the borrower at closing be limited to 2 percent, provided there are no substantive changes in the transaction. Penalties would be imposed for violations of the 2 percent threshold.

In my view, the threshold should be zero, since lenders and brokers know their own charges. But, hey, 2 percent is not much; it means an estimated charge of $3,000 could increase only to $3,060. Considering the source of the proposal — mortgage bankers proposing that discipline be imposed on themselves — HUD ought to jump at it. Since no other interest group is likely to object, it should have clear political sailing.

Third-party charges are another matter. The MBA also proposes a limit on deviations between the third-party charges including title costs contained in the GFE and those paid by the borrower at closing. They would cap the deviation on the total of such charges at 10 percent. This would curb some of the worst low-balling, but it would not do anything to reduce third-party charges, which are far higher than they would be if they were sold in competitive markets. I will have an article about this next week.

Investing the Cash Flow Savings on an Interest-Only: Will it Pay?

“I am considering the 6.375 percent interest-only version of a 30-year fixed-rate mortgage, as opposed to the standard version at 6.25 percent. My idea is that if I can earn more than 6.375 percent on the cash flow savings, I should end up ahead. True?”

No, you have to earn more than 8.35 percent to come out ahead.

If you take the standard version, the fully amortizing monthly payment at 6.25 percent is $1,847, and after 10 years, your balance would be $252,712. You would thus pay down the loan balance by $47,288 over the 10 years.

If you take the interest-only version, and don’t make any principal payments, the balance after 10 years remains at $300,000. The interest-only payment at 6.375 percent is $1,594, or $253 less than the fully amortizing payment of the standard mortgage. To break even, therefore, the monthly cash flow saving of $253 must accumulate to $47,288 over the 10 years.

The break-even rate of return is 8.35 percent. This is the rate that must be earned on the monthly investment of $253 to generate a fund of $47,288 in 10 years. It is higher than the rate on the interest-only because it must offset the interest rate difference between the interest-only and the fully amortizing versions.

To come out ahead, you must earn a return greater than 8.35 percent. Few people can do that without taking a lot of risk.

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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