Yield Spread Premiums aren’t all bad

After reading yet another politician’s proposed solution to foreclosure problems and shaking my head at the stupidity of it all, I decided yield spread premiums need some explanation. YSPs are often trumpeted in the news as this huge secretive lending method of raking thousands of dollars from unsuspecting borrowers. YSPs can be used that way, be there are also other uses.

When a person applies for a home loan, purchase or refinance, there are usually different options in the amount of fees charged and options in the interest rate of the loan. Some of the fees are fairly fixed, such as for title insurance and possibly escrow fees, but some of the single largest fees are “points”. A point is simply 1% of the loan amount with two different types of points being charged. Origination points are what the lender charges to originate the loan, discount points can be used to reduce the interest rate on your loan. If the interest rate on the loan is higher than the lowest possible interest rate the borrower qualified for, then a yield spread premium is paid to the originating lender.

That last paragraph was a little cumbersome, so let’s recap.
You pay discount points, you get a lower interest rate.
You pay a higher interest rate, the originating lender gets the yield spread premium.

Market forces tend to keep most abuses in check because people shopping for home loans follow interest rates very closely and they’ll be aware if their quoted rate is higher than what is available from other lenders. So why should there even be a YSP?

Let’s take Joe, an average borrower who doesn’t have much money saved but has been diligently making his house payments for the last several years. Interest rates have dropped and he can save quite a bit of money on his monthly payment by refinancing, but he doesn’t have money in the bank to pay for the loan fees and doesn’t want to increase his loan amount to cover those refinance loan costs. Using a slightly higher interest rate and the YSP due to that higher rate, the originating lender can pay for origination fees and loan costs allowing Joe to get a new lower interest rate with no out of pocket costs and no increase in his loan balance.

YSPs have their place and can serve a useful purpose, legislation requiring the absolute lowest interest rate possible might protect some people, but there are an awful lot of “Joes” out there that certainly won’t be helped.