Last week Department of Housing and Urban Development Secretary Mel Martinez announced new disclosure rules designed to prevent unexpected loan fees at settlement. Among the details of the new policy, HUD sought to clarify its position on "yield spread premiums" or "YSPs". YSPs are fees paid by a lender to a mortgage broker in return for the delivery of a loan that carries a higher interest rate.

HUD has stated that YSPs are not "illegal kickbacks" as some interest groups have charged, but serve "an important purpose" by allowing low-income borrowers to pay lower fees at settlement in return for a higher interest rate.

The yield spread premium controversy has been going on for years. As an owner of a mortgage company that has originated thousands of loans with YSPs, here is my view.

The motivation behind the concern of YSPs is well intentioned but perhaps misguided. A lender will happily pay an up-front fee to a mortgage broker if it can receive a loan with a higher interest rate.

Is that a kickback? No. It's a fee paid by the lender to the broker. Critics of YSPs charge that mortgage brokers steer their clients to lenders who pay YSPs so the broker can reap bigger fees. In some instances there are a few unscrupulous brokers who "price gouge" unsuspecting borrowers. But an unscrupulous broker doesn't need a YSP to gouge. He can simply charge more points to the borrower.

The plain fact is that in the vast majority of loans where YSPs are paid, these fees are used to offset the borrower's typical closing costs.

Let's take today's refinance boom and look at some real life situations.

We have a borrower who's paying 8 percent on a 30-year fixed rate loan with a balance of $200,000. He wants to refinance. He checks the newspaper, calls a few mortgage brokers and receives the following quotes:

• 6.50 percent with closing costs and one point (One point equals one percent of the loan amount. For a $200,000 loan a single point would be worth $2,000.)

• 6.75 percent with closing costs but no points.

• 7 percent with no points or closing costs.

For a $200,000 loan, the closing costs will total something close to $2,000. This can vary from state to state and includes items such as appraisal fees, title insurance, attorney's fees, etc.

So the 6.50 percent loan with closing costs and one point will cost the borrower perhaps $4,000 to close the deal. A 6.75% rate will cost roughly $2,000. The higher rate of 7 percent carries no fees or points whatsoever. Yes, the interest rate is higher. There's no free lunch.

The only way the mortgage industry can offer no point or no cost loans is by offering a higher interest rate with a YSP. The way it works is very simple. The lender pays a mortgage broker to deliver a loan with an interest rate of 7 percent. The money paid to the mortgage broker is the yield spread premium. The broker then pays the borrower's closing costs with the YSP. The broker keeps the difference for his pocket. The borrower receives a rate of 7 percent without having to pay huge cash costs at closing.

So you tell me -- are YSPs a nothing but a kickback to gouge American consumers? No, the mortgage business is fiercely competitive. Let's go back to the original example.

The difference in monthly payment between 6.50 percent and seven percent on a $200,000 loan is $67 per month. Here's the bottom line: Are you prepared to spend $4,000 in non-refundable fees to save an extra $67 per month over the life of the loan?

Before you answer that question, remember that interest is tax deductible. After the tax savings, the difference in monthly payment may only be $60 per month. Also, it's important to understand that if you pay these fees out of your savings account, you will lose the interest earned on the $4,000. If your bank pays 4 percent interest, this means you will lose $160 per year, or $13 per month. Subtracting $13 from our difference of $60 now gives us only $47 per month.

So, the question arises. Is it worth spending $4,000 in non-refundable fees to save $47 per month over the life of the loan? If we divide $4,000 into $47 we see that it will take 85 months to recoup our costs. That's over seven years. So if you are 100 percent sure that your will not sell your home or refinance in the next seven years, perhaps it makes sense to pay the four grand and get a lower rate.

From my experience, however, most American homeowners are not sure. They'd rather keep their money and take a rate that's a little bit higher.

This is what yield spread premiums are all about. Without YSPs, the American consumer would not be given the choice to take a higher rate with lower fees. Every mortgage loan would cost the borrower hundreds or thousands of dollars in cash at closing.

As I've said many times before, be a smart consumer. Use a mortgage company that's recommended by a friend or family member and check around a bit. This will ensure that you don't get ripped off. But don't allow misguided legislation take away your ability to obtain a low cost loan.

For more articles by Henry Savage, please press here.

Published: October 24, 2001

Use of this article without permission is a violation of federal copyright laws.

, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.