By definition, a broker is a person who arranges or negotiates something like a settlement, deal, or plan. It follows that mortgage brokers arrange or negotiate a mortgage. But what does “arranges or negotiates” really mean?
More importantly, does a mortgage broker always act in the best interest of their customer, the mortgage borrower?
These questions come up whenever we meet with financial advisors. Understanding the answer (hint: it is not a simple yes or no) is essential for a fiduciary advisor who wants to remain, well, a fiduciary advisor. Failing to understand this answer results in failing to look out for the best interest of your client.
Let’s examine how mortgage brokers come up with their mortgage rates.
How mortgage brokers come up with rates
A mortgage broker will compare various wholesale lenders when examining loan options for a potential customer. Wholesale lenders (which have approved the mortgage broker as a partner) will supply rate sheets or the raw data to populate loan pricing software.
In this sense, wholesale lenders are just like wholesale suppliers in a retail market. They can have specialties such as “jumbo loans” and rate or pricing differences will certainly exist amongst them.
The graph below represents the wholesale price from three different wholesalers available to a mortgage broker. For our purposes, we’ll imagine there are just three different wholesale lenders being considered for a particular loan. Truth is, there could be many more options considered by one mortgage broker.
To grasp the concept of how this process works we are omitting the actual interest rates. Rather, we are going to focus on their relative position to each other. Note the Y-axis is simply “Interest Rate” and void of specific numbers.
In the case above, Wholesale Lender 1 is offering the lowest wholesale rate given the mortgage customer’s credit, income, and other criteria. In contrast, Wholesale Lender 3 is providing the highest wholesale rate. Lower rates are always better when other things such as origination fees and discount points are held constant.
With an understanding of the mortgage broker’s “suppliers,” let’s move on to how the mortgage broker makes money.
A mortgage broker adds margin
A mortgage broker will add a retail margin, or markup, to each wholesale rate. These two items, when combined, determine the final interest rate presented to the mortgage customer.
Industry compliance and several other factors ensure that a specific mortgage broker earns the same markup on each loan they could offer. As a result, the same margin is added on top of each wholesale rate.
With the retail margins added to each wholesale price, the relative attractiveness does not change. Wholesale Lender 1 + broker margin is still the most attractive loan option. Said another way, this wholesale price and the margin combined will result in the lowest rate for the mortgage customer.
A mortgage broker presents their best option
Mortgage brokers want to present their best option to increase their chances of winning the loan business. They are indifferent as to which option they provide because they generate the same margin in all cases. In this sense, a mortgage broker does “shop” rates in some way. But there is MUCH more to the story.
The fact is, there are many wholesale lenders and a mortgage broker selects a certain number with which to partner. While a mortgage broker may have access to many wholesale lenders, they will NEVER have complete representation.
Other mortgage brokers have their own best options
Each mortgage broker has an individual set of wholesale relationships. These relationships can be based on familiarity, proximity, or any other factor.
Additionally, each mortgage broker must be approved by a wholesale lender in order to offer their products and terms. Some wholesale lenders enforce minimum production requirements in order for mortgage brokers to remain “active” with them. Further, certain mortgage brokers can receive better/worse wholesale pricing based on a range of factors including quality of submissions and volume of transactions monthly/quarterly.
As a result of these factors, each mortgage broker will have access to a “best wholesale price.” Said another way, they will each have a different starting point with which to build their retail rate.
Mortgage Broker 1 has presented the wholesale price that is lowest from his stable of options. Mortgage Broker 2 has access to a lower wholesale price. Mortgage Broker 3 has access to a less favorable wholesale price – the worst of the bunch.
If we assumed (wrongly, btw) that retail margins are all the same, then we see (below) how a wholesale price is related to a lower rate. In these cases, the wholesale price is the main determinant of interest rate for the consumer.
When presented with these options, we should choose to work with Mortgage Broker 2. Due to their exclusive access to the lowest wholesale price (amongst the three), they will provide the lowest interest rate.
A lower interest rate results in lower monthly mortgage payments – who wouldn’t want that?
Retail margins differ between mortgage brokers
Mortgage brokers generate revenue only when they produce loans. All expenses, such as loan officer commissions, office overhead, and marketing/advertising, are paid for from this transactional revenue. As a result, each mortgage broker requires a different retail margin to maintain profitability and the range can be significant.
Operational overhead is one of the most common reasons why retail margins range. A mortgage broker with a large executive team (drawing hefty salaries) will result in the need for larger retail margins.
A mortgage broker paying a hefty monthly “marketing expense” to a real estate office can also be a contributing factor. These monthly fees, called MSAs, are masked from compliance regulators by associating them with “joint marketing activities.” While the legality of them may be increasingly questionable, the funds required to repay this large expense increases the retail margins charged.
Applying the logic from above, let’s take a look at how our Mortgage Brokers made out in a competitive environment.
Mortgage Broker 2 ends up being the worst choice for a mortgage borrower. The large retail margin results in the highest interest rate compared to both other options.
Mortgage Broker 3 ends up with the lowest rate for a mortgage borrower. Their low retail margin means they can provide the best interest rate, resulting in the lowest payment compared to the other two options.
Shopping between mortgage brokers is vital
According to the Freddie Mac April 2018 Insight, shopping just one additional source for a mortgage can result in savings approaching $2,000. Shopping up to five sources can result in savings that approach $4,000.
While these numbers may seem significant, we see rates vary by as much as 0.50% between mortgage brokers. This difference presents a more significant opportunity than the Freddie Mac April Insight suggests.
Because mortgage brokers can’t represent every single wholesale option and inevitably have a differing retail margin, they can only partially act in the best interest of a customer.
Despite advances in technology and efficiency, mortgage shopping is a vital part of the mortgage process and should be done in each and every instance.