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Avoiding Markups on Third Party Settlement Services

Avoiding Markups on Third Party Settlement Services

December 17, 2001

�The Federal appellate court in the 7th circuit recently ruled that it is legal for lenders to make a profit on third party services sold to borrowers, such as appraisals and credit reports. In contrast, HUD has always said that markups were illegal if there were no services provided in connection with them.  Who is right, and if the court ruling stands, how can borrowers protect themselves against excessive charges?�  

 I�m with the court on this one.  HUD�s rule is essentially unenforceable and was widely violated before the recent court decision.  Having unenforceable laws on the books that are routinely violated does not protect the borrower, and undermines respect for the law.

There is a case for prohibiting markups in this market.  Loan providers are not restricted in their ability to charge directly for their services.  Indeed, the list of fees that one or another loan provider charges is bewilderingly long.  Markups aren�t needed to assure that loan providers are adequately compensated, and create one more layer of complexity for consumers.  

Indeed, if I were mortgage czar rather than professor, I would prohibit all markups, and limit loan providers to two fees: one expressed as a percent of the loan (�points�), and one expressed in dollars (�total fees�).  This would drastically simplify life for borrowers without in any way restricting the ability of loan providers to charge for their services. 

In the world that exists, however, it is better to permit markups.  The alternative to permitting markups is not my ideal rule but an actual HUD rule that allows markups if additional services are provided but prohibits them otherwise.  While the HUD rule may appear fair, it is not because it is not enforceable -- except very selectively, which is unfair.  The vast majority of loan providers know they are beyond HUD�s reach.

Violations of the HUD rule were pervasive before the recent court decision.  Hence, the problem that markups on third party services pose for borrowers will be little different in the future than it was before the recent court decision.

What does a borrower do to protect against unjustified markups?

Let me begin with what not to do.  Another columnist advises borrowers: 

�Don't be asleep at settlement -- demand to know why you're being charged $60 for a credit report instead of much less, and take a hard look at other fees if they seem high.�

If the borrower doesn�t wake up until settlement, he might as well go back to sleep for all the power he will have to affect the outcome.  To expect that a borrower will be able to talk down fees at settlement because they �seem high� is unrealistic.  The lender will have ready explanations for every charge, and the borrower�s clout in protesting them is zilch.

For example, the loan provider can explain that the $60 charge for the credit report includes the lender�s cost to extract the critical information from the report and analyze it.  That will end the discussion and the charge will remain. 

A borrower who awakens prior to closing may have more success.  If it is a refinancing, the borrower can threaten to walk from the deal.  If it is a home purchase and a real estate agent recommended the lender, the borrower can enlist the agent to intervene with the lender.

Another not-so-great idea is for borrowers to order their own services.  Loan providers will strongly resist it, for good reason.  They know they will have to instruct the borrower how to do it, and then monitor the results, which takes more of their time than if they did it themselves.  Loan providers expect to be compensated for their time, so if you demand more of it to reduce their fees on third party services, they will look to make it up elsewhere. 

The fact is that markups on third party services, when they occur, are the smallest part of a loan provider�s compensation.  It makes no sense to try to save $150 on the appraisal if it costs you the equivalent of $500 elsewhere in the deal.   Borrowers should be concerned with the total, not one part of the total. 

There are two approaches to this problem that I�ll call the shopping approach and the agent approach.  Both approaches are part of broader strategies toward shopping, and are deployed during the process of selecting your loan provider.  Neither approach focuses on markups in isolation, because markups are the smallest part of your total credit cost. 

The shopping approach simply means that you shop total fees paid to the loan provider, and to third parties providing services ordered by the loan provider.  This total is what matters.  You don�t worry about individual fees � for example, why A charges for courier service when B down the street doesn�t.  And you don�t worry about markups because they are included in the total. 

While it is the total that matters, to get it you must tell the loan provider exactly what you want.  The relevant categories are:

Fees Paid Before Closing: Most settlement costs are paid at closing; if the loan doesn�t close, there is no payment. There are two types of costs, however, which are paid before closing and may not be reimbursed if the loan doesn�t close.  One is an application fee, which is due at the time the application is submitted.  The second is a commitment or lock-in fee, due at the time the terms are locked by the lender.  Neither of these fees are common today.

Fees Retained by the Lender Expressed as a Percent of the Loan:  This includes two charges: "points" and "origination fee".  While lenders always quote points when they quote the interest rate, they often delay disclosing an origination fee. 

Fees Retained by the Lender Expressed in Dollars: This includes a wide variety of charges imposed by and paid to the lender or broker, which are expressed in terms of dollars rather than as a percent of the loan.  They are sometimes known collectively as �junk fees�.

Charges paid to third parties:  These are payments to third parties for services that lenders require.  The most common are appraisals and credit reports.  Lenders and brokers know what these charges are, even though they do not receive the payments, and they may mark them up. 

Fees paid to mortgage broker:  If you are dealing with a mortgage broker, the broker's fees to you should be included.  The major fee will usually be expressed as a percent of the loan, and is therefore similar to points.  Brokers will also often charge a processing fee expressed in dollars. 

Convert the fees expressed as a percent of the loan into dollars and add up the total.  Assuming the interest rate quoted by loan providers is the same, you select the one offering the lowest total fees. 

If loan provider A quotes lower fees but a higher interest rate than B, you need to know which will cost the most over the period you expect to be in your house.  For this purpose, you can use one of the �interest cost comparison� calculators on my web site.

All the fees listed above are included in a required disclosure called the �Good Faith Estimate of Settlement Costs" (GFE).  However, the lender has until 3 business days after you complete an application to provide this statement, which makes it useless for shopping purposes. Even if you received it earlier, it is so poorly designed that it can as easily lead you astray as help.  See Does the Good Faith Estimate Help?

The agent approach to avoiding excessive markups is simpler.  You negotiate a fee with a mortgage broker to act as your agent in shopping for a loan.  The broker fee is all-inclusive, so any markups are included, and it is net of any payment to the broker by the lender.  The broker then shops on your behalf for the best deal available from lenders, including lender fees.

The mortgage broker must be willing to deal with you as your agent, rather than as an independent contractor, which is the general practice.  Upfront Mortgage Brokers prefer to work this way, but many other brokers would be willing to if customers requested it.

Copyright Jack Guttentag 2002



Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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