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What is a Yield Spread Premium for a Mortgage?
Definition
A yield spread premium is the difference between the interest rate you pay on your mortgage and the interest rate required by the funding lender or government sponsored enterprise (GSE), company or investor that purchases the mortgage.
How Does a Yield Spread Premium Work?
A yield spread premium is a relatively complicated concept so the best way to understand it is to think about the difference in the wholesale and retail price for a product. For example, if you purchase a television at a retailer you pay the retail price for the television. The retailer pays the television manufacturer a wholesale price, which is lower than the retail price it charges you. The “spread” or difference between the wholesale price the retailer pays and the price you pay is the profit that the retailer keeps when you buy the television.
The same general concept applies to mortgages and in this case the spread between the wholesale mortgage rate and the retail rate you pay is called the yield spread premium.
Yield Spread Premium for a Mortgage Broker
A yield spread premium is most commonly associated with mortgage brokers which provide a good example of how a yield spread premium works. A mortgage broker does not directly fund your mortgage but instead comparison shops multiple funding lenders to find borrowers the mortgage with the best terms. The funding lenders, also known as wholesale lenders, quote the interest rate they require on a loan, which is also referred to as the wholesale rate. Mortgage brokers have discretion to charge you an interest rate that is higher or lower than the wholesale rate charged by the funding lender so they effectively serve as a mortgage retailer.
If the mortgage broker charges an interest rate that is higher than the wholesale rate required by the funding lender, this is called a yield spread premium. In this scenario the mortgage broker receives a fee or commission from the wholesale lender for delivering a mortgage with an interest rate that is higher than the wholesale rate. So instead the borrower paying an origination fee, the borrower pays the higher retail mortgage rate and the mortgage broker is compensated by the commission received from the wholesale lender. The higher the interest rate, the higher the yield spread premium, the higher the commission the funding lender pays to the mortgage broker. In reality, however, the borrower pays the commission indirectly by paying a higher mortgage rate.
The mortgage broker also has the option to charge you an origination fee instead of charging a higher rate. In this case the borrower pays an origination fee directly to the mortgage broker and the mortgage broker receives no commission from the wholesale lender because they charged the borrower the wholesale rate. If you want a mortgage rate that is lower than the wholesale rate charged by the funding lender then you can pay discount points, which are extra fees borrowers have the option to pay to lower their mortgage rate.
In short, the yield spread premium is the difference between the wholesale interest rate and the retail interest rate you actually pay on your mortgage. The higher your interest rate, the less closing costs you should pay on your mortgage and in some cases you may receive a rebate to pay for closing costs. For example, a “no cost” mortgage charges a higher interest rate than a mortgage with standard closing costs and fees. And vice versa, the lower the interest rate, the higher the closing costs you should pay on your mortgage.
Example
The example below compares the interest rates and fees for a $200,000 mortgage with a 4.000% wholesale interest rate and a .750% yield spread premium to a mortgage with no premium. The mortgage with the .750% premium requires the borrower to pay no lender origination fee but a higher interest rate (4.750%) while the mortgage with no premium requires the borrower to pay a 1% origination fee, or $2,000, but the borrower pays a lower interest rate (4.000%). This represents only one example but allows you to understand how the yield spread premium impacts your mortgage rate and lender costs.
- Mortgage 1: $200,000 Loan with .750% Yield Spread Premium
- Wholesale Interest Rate: 4.000%
- Premium (%): .750%
- Interest Rate Paid by Borrower: 4.750%
- Lender Origination Fee (%): 0%
- Lender Origination Fee ($): $0
- Mortgage 2: $200,000 Loan with No Yield Spread Premium
- Wholesale Interest Rate: 4.000%
- Premium (%): 0%
- Interest Rate Paid by Borrower: 4.000%
- Lender Origination Fee (%): 1% of Loan Amount
- Lender Origination Fee ($): $2,000
Yield Spread Premium for Other Types of Lenders
Although mortgage brokers provide the most clear example of how a yield spread premium works, they effectively apply to all mortgages from all types of lenders. Most mortgage originators such as banks, mortgage banks and credit unions sell the loans they originate to other companies, investors or government sponsored entities (GSEs) such as Fannie Mae or Freddie Mac. Mortgage originators sell loans because it enables them to turn around and offer more mortgages and make more money from fees. When a bank sells a mortgage, the party buying the mortgage requires a certain interest rate on the loan. The mortgage originator usually charges an interest rate that is higher than interest rate required by the party that buys the loan. So even though the bank, mortgage bank or credit union funds your mortgage directly (unlike a mortgage broker) the concept of the yield spread premium applies. The mortgage originator profits from the spread between the retail interest rate they charge borrowers and the interest rate required by the party the buys the loan.
- Use ourMORTGAGE COMPARISON CALCULATOR to compare loans with different mortgage rates and closing costs
After the Mortgage Crisis
In the past, mortgage brokers were required to disclose the yield spread premium they received on mortgage disclosure documents whereas funding lenders were not required to disclose their premium. Revised mortgage disclosure laws enacted as a result of the mortgage market crisis, called TRID, no longer require mortgage brokers to disclose their premium, placing them on equal ground with other mortgage originators.
Some industry analysts claim that the new laws “eliminated” the yield spread premium in response to abuses by certain lenders who charged both a high yield spread premium (mortgage rate) and high origination fees. In reality, although the premium is no longer disclosed on mortgage disclosure documents it remains a key factor in determining your interest rate and closing costs. Brokers and other lenders have significant discretion over the mortgage rates and fees they charge borrowers as compared to the wholesale rate or rate required by investors that buy mortgages. The new laws, however, prohibit lenders from charging borrowers both a yield spread premium and an origination fee on the same loan.
What Borrowers Should Know
For all the complexity, confusion and attention that surrounds the yield spread premium it is not a figure that borrowers should focus on directly when they shop for mortgage. In fact, most lenders do not disclose their premium to borrowers. From a practical standpoint, the actual premium really does not matter because it is already built into the mortgage rate and closing cost quoted by lenders. Understanding how the premium works may allow borrowers to negotiate better mortgage terms but ultimately you compare rates and fees to select a mortgage. That is why we recommend that borrowers compare at least five lenders when shopping for a mortgage.
The table below shows mortgage rates and fees for leading lenders in your area. Contact multiple lenders to request loan terms. Comparing multiple lenders and proposals is the best way to save money on your mortgage.
Sources
"Federal Reserve announces final rules to protect mortgage borrowers from unfair, abusive, or deceptive lending practices that can arise from loan originator compensation practices." Press Release. The Federal Reserve Board, August 16 2010. Web.
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