June 21, 2013

Competition is generally viewed as a good thing, in the US at least. Hence, advertisements that create an image of powerful banks having to compete among themselves for the favor of individual mortgage borrowers creates a generally favorable impression. The problem is that competition generates favorable results only under certain conditions, and those conditions are very difficult to find in the home mortgage market.  

To illustrate, consider a market in which head-to-head competition by banks does clearly benefit consumers: the market for insured certificates of deposit (CDs). Competition works in the CD market because CDs are easy for consumers to shop. They merely look for the highest interest rate for the term and the amount they want to commit. Today, they can find this information at any number of web sites.  

CDs are easy to shop for three reasons, none of which apply to the home mortgage market. 

The price is one-dimensional.  In the CD market, the price is the interest rate, and while banks can differ in how often the rate is compounded, the effect of this on the yield earned by the consumer is negligible. This makes shopping easy, even for the arithmetically challenged. 

In contrast, the price of home mortgages is multi-dimensional, consisting of an interest rate plus upfront fees, some expressed as a percent of the loan amount (“points”), and some specified as fixed dollar amounts. This complicates the process enormously because it means that the lowest price depends on how long the borrower expects to have the mortgage, which varies from case to case.  

Note: The Federal Government has tried to fix this by requiring lenders to disclose a measure called the Annual Percentage Rate, or APR, which reflect both the rate and the fees. But in calculating the APR, lenders must assume that all borrowers have their mortgage for the full term, which defeats its purpose.  

This uncertainty as to what constitutes a “best price” makes it difficult for consumers to compare offerings of competing providers. 

The quoted rate applies uniformly to all consumers: The bank pays the same CD rate to all consumers. In contrast, mortgage prices vary with the features of the transaction. These include loan size, ratio of loan amount to property value, credit score, type of property, state of property location, and type of occupancy.  

Because mortgage prices are specific to a transaction, price quotes are often inaccurate. Consumers may not have all the relevant facts right, and loan providers have little incentive to invest the time in providing accurate quotes to borrowers who are price-shopping. It is easier to assume the best features, which produces the lowest price.  

The quoted price is valid. Consumers shopping for a CD can be assured that a bank quoting a rate is prepared to pay that rate to a consumer electing to do business with it.

 In contrast, the prices quoted to mortgage borrowers by loan officers and other intermediaries may or may not be valid. Intermediaries can quote bogus prices with impunity because quoted prices can’t be converted into a firm commitment of the lender (a “lock”) until the borrower has  been approved for the loan, by which time prices have changed. Loan approval takes days often running into weeks, whereas lenders reset their prices every day, and often within a day.  

Quoting a price to a shopper below the valid price, called “low-balling,” is common practice in this market. It is especially common among originators who know they are being price shopped. 

In sum, competition based on solicitation of price quotes from alternative sources, which works to the advantage of consumers in the CD market, does not work in the home mortgage market. Consumers who solicit price quotes by calling 3 or 4 loan providers are wasting their time. Many realize this and select just one, often based on a referral, and hope for the best.  

Some consumers solicit quotes through a web site that promises that 3 or 4 lenders will compete for their business – a “lead generation site”. One of the largest of these is the source of the “When banks compete, you win” ad. 

Lead generation sites collect transaction and contact information from consumers, which they sell to 3 or 4 lenders who contact the consumer with price quotes. Competition in the market for leads works very well; the leads go to the lenders who will pay the most for them. 

Lead generation sites are marginally better for the borrower than calling 3 or 4 lenders on the phone because lenders who purchase leads may have enough information to quote valid prices. However, the borrower has no way to determine which loan providers are low-balling to win the deal. The Achilles heel of lead-generation sites is that, in many cases, the biggest liar wins the deal. 

Consumers shopping for a mortgage who want assurance that all quoted prices are valid should seek multi-lender web sites that post prices received directly from lenders, not prices submitted by intermediaries. A list of such sites can be found at How Effectively Can You Shop at Multi-Lender Web Sites?