It is awfully nice of lenders to be offering free loans. At least, that's what it sounds like they're doing—at least in all of those internet ads or e-mails trumpeting loans at super-low rates with no out-of-pocket costs.
Have you ever wondered how lenders can do this? If they are not charging you, the money has to come from somewhere. It helps to clear things up when you understand how a loan officer makes their money.
- Loan officers are compensated either "on the front"—via fees you pay upon getting your loan—and/or "on the back," a commission from their institution (which you indirectly pay via a higher interest rate).
- The good faith estimate a lender gives you delineates the APR on your loan, which represents its total annual costs.
- Beware of loan officers that push you into adjustable-rate mortgages or into refinancing.
- Using a mortgage broker might find you better terms than dealing with an individual loan officer.
How Mortgage Loan Officers Get Paid
Loan officers get paid in a way that they call "on the front" and/or "on the back." If a loan officer makes money on the front, that means they are charging for things that you can see—miscellaneous charges for processing your loan, often categorized as settlement costs or processing fees. You can pay these fees out-of-pocket when you sign the papers, or incorporate them into the loan.
If a loan officer makes money on the back, that means money is being received from the bank as a sort of commission for filing the loan. This is the money you do not see. When lenders claim to be giving you a "no out-of-pocket" or "no-fee" loan, they are still making money, but they are charging it on "the back."
So isn't that better for you? Not necessarily. Although the bank is paying the loan officer a commission now, the money is really coming from you, the borrower—in the form of a higher interest rate. Lenders that are not charging fees on the front can be charging a higher rate to make up for lost fees. In fact, the lending institution could be making a lot more money this way as they are getting a higher rate of interest for possibly 30 years or more.
Comparing Loans to Discover Costs
When you apply for a loan, the loan officer must give you a good faith estimate—sort of a preview of your mortgage and its terms. That estimate includes the APR on your loan, which demonstrates the entire cost of the loan to you on a yearly basis—factoring in what the fees cost as well as the interest rate. By comparing good faith estimates and their APRs, you can get a better idea of what lenders are planning to charge you.
A comparison often will make abundantly clear that, as they say, there is no such thing as a free lunch. You might not be paying money out-of-pocket right now, but either you pay now or you eventually pay later. Many times it is a better deal to pay the fees now to get a lower rate instead of paying a higher rate over 30 years.
Loan Officer Pitches
Remember, despite their authoritative-sounding name, loan officers are salespeople; they get paid by selling you something—specifically, a loan. And the loan that best benefits them may not be in your best interests.
For example, be careful of the loan officer who wants to sell you an adjustable-rate mortgage (ARM), and then keep on selling you after ARM after ARM for the same property. ARMs are a good choice for certain people, especially those who know they won't be in their home very long or plan to pay off the loan in full within a certain period. However, if you are planning to stay in your home for more than seven years or so, an ARM may not be a very good choice, since the interest rate could dramatically increase on you.
It behooves officers to make as many loans as possible. One way to do this is to get people into ARMs that may need to be refinanced often. When they are telling you it is a good time to refinance—whether it's an ARM or a fixed-rate mortgage—you need to figure out how much that loan is going to cost you. To do this, you must consider how many out-of-pocket fees you will be paying, if the loan interest rate is less, and if you'll be in the loan long enough to recoup these expenses. If you are getting a lower interest rate and not paying any fees, it could be a better deal than what you have now.
Mortgage Broker vs Bank Loan Officer
Sometimes the people behind those tempting ads are not bank loan officers themselves, but mortgage brokers. Brokers serve as an intermediary between borrowers and lenders; they do not service loans themselves. If a loan is approved, the mortgage broker collects an origination fee from the lender as compensation.
The advantage of using a broker for you, the borrower, is brokers can shop around at the different banks for the lowest rates, whereas a loan officer can only deal in the rate offered by his institution. The advantage of using a bank directly is that they don't have to pay the broker a fee—the cost of which, you can bet, is eventually going to come out of your pocket, one way or another. If the broker can find a lower rate, charge their fee, and still offer the most advantageous loan, then they may be your best choice.
You will have to do your homework and compare good faith estimates to be sure. Remember, the loan officer decides how much money they want to make to some extent; they may have some negotiating room. Don't always expect that brokers will give you the best rate that they can. They may not be telling you the lowest rate they can offer because by offering the rate they originally quoted, they may be getting more commission on the back-end.
The Bottom Line
How can you best protect yourself? Do your research. Shop around. Do not accept the first good faith estimate. Get several estimates. Compare the APR on each one. Go to both brokers and bankers to see what they offer.
Be wary of the loan officer that doesn't ask you how long you will be living in your home. If they don't ask you questions, they don't know which loan fits you the best. If you are planning to only be in your home a short time—less than a decade or so— you might consider an ARM. If you are going to be there for a long time, consider a 30-year loan. Even better, if the day comes and you can afford it, pay extra each month on your 30-year loan and pay it off in 15 years instead.