Brokers Becoming Creative With Mortgage Rates, For Better Or For Worse?
Lenders have put an end to brokers offering lower mortgage rates.
Lenders don’t want brokers selling you too low of an interest rate, discounting restrictions are now in effect. In response brokers have had to become creative in order to offer consumers greater savings. The problem is a handful of brokers have confused creativity with inaccuracy, and their mistakes can cost you.
Why discount restrictions?
An interest rate “buy-down” is when the broker has exchanged some of his or her commission for a bigger discount on your mortgage. Mortgage brokers, like bank reps, can usually sell you a lower rate if they want to.
However, brokers can only go so far. Many banks and credit unions limit broker buy-downs to a set amount like 0.10, 0.15 or 0.25 percentage points off standard rates. They do that to protect their retail franchises from aggressive rate competition and/or to prevent too low a yield when they sell mortgages to investors.
Where there’s a will there’s a way
Lenders may be able to stop deep rate discounts but they can’t prevent a broker from giving you cash. So some brokers are now advertising what are called “cashback effective rates.” Cashback effective rates are notional rates that are lower than the lender actually allows. Essentially, the broker figures out the interest cost difference between the lender’s actual rate (a.k.a. the “contract rate”) and the rate they want to give the customer.
The broker then pays cash to the customer, equivalent to the total interest savings of that lower rate.
3 positive reasons this is good.
1) It helps people secure lower overall borrowing costs than they’d otherwise obtain from the lender.
2) It pays down the mortgage quicker since the payment is slightly higher with the higher rate, assuming the borrower uses the cash to prepay the mortgage.
3) The borrower often gets more cash than they’re due as most brokers don’t apply present value discounts to their cash rebates. In other words, if the higher contract rate means you’ll pay $20 more four years from now, most brokers will give you $20 today even though $20 today is worth more than $20 in the future.
A tiny number of brokers seem to have a math impediment. They’re essentially overcharging borrowers because they don’t calculate the cash rebate correctly. Essentially this means they’re breaking laws that require rate advertising to be clear and not misleading.
Some brokers are calculating the cash rebate as the interest cost difference (e.g., 0.10 per cent) multiplied by the mortgage amount. That meant they were only paying the borrower about one year’s worth of interest savings even though it was a five-year mortgage! Making their offering more of an illusion.
The right way of doing things
According to Prof. Milevsky, the correct way to calculate the rebate on a cashback effective rate is to:
A) Determine the payment difference for each month of the term;
B) Compute the present value of those payment differences each month (using the lower of the two rates as the “discount rate,” which is the rate that makes a future sum of money equivalent to an amount today);
C) Total these amounts;
D) Determine the difference in ending balances for each mortgage;
E) Compute the present value of that difference;
F) Add C and E together and give that amount to the borrower.
If your broker runs two amortization schedules – one for each rate – and then rebate the interest cost difference between the two then they can provide a fair and honest rebate and you can verify that interest cost difference with a mortgage calculator.
The point is
Cashback effective rates were born out of a competitive online mortgage market, where advertising lower rates can be a brokers only means of staying competitive. We expect this trend to continue.
If you choose a cashback effective rate, check the math with an online mortgage calculator or have your accountant look it over.
When calculated and disclosed properly, they are beneficial to consumers.