Definition
Yield Spread Premium (YSP) is a financial term primarily used in the mortgage industry. It refers to the money or rebate a lender pays a mortgage broker for originating a loan with an interest rate above the borrower’s qualified rate, resulting in the borrower paying a higher interest rate. This premium is essentially the broker’s compensation for selling a loan with a higher interest rate to borrowers.
Key Takeaways
- The Yield Spread Premium (YSP) is a financial term used mainly in the mortgage industry. It represents the extra interest that a borrower pays over the life of a loan, and concurrently, the commission that a lender receives for selling an interest rate above market rates.
- YSP is commonly linked with adjustable-rate mortgages and is considered controversial because it could incentivize brokers to recommend loans that are not in the best interest of the borrower. This form of compensation to brokers was a contributing factor to the subprime mortgage meltdown and has come under increased scrutiny and regulation.
- Post the financial crisis of 2008, the Federal Reserve issued new rules prohibiting mortgage brokers and lenders from receiving compensation that is based on the interest rate or other terms of the loan. This action essentially prohibited the use of Yield Spread Premiums from being used in loans.
Importance
The finance term, Yield Spread Premium (YSP), is a crucial concept primarily in mortgage lending where it refers to the compensation a lender pays a mortgage broker for providing a loan with an interest rate above the least costly option available.
This difference between the actual rate of a loan and the rate that the lender would have offered for a risk-free loan forms the YSP.
Its significance lies in the fact that it directly impacts the cost of the loan for the borrower by increasing their mortgage payments, and hence their long-term financial commitments.
While it can serve as an incentive for brokers to assemble and finalize home loans, it may steer towards potential predatory lending practices if not adequately regulated.
Therefore understanding a Yield Spread Premium is vital for individual borrowers, financial brokers, and regulatory authorities.
Explanation
The Yield Spread Premium (YSP) plays a significant role in the mortgage industry, predominantly serving as a compensation method for mortgage brokers and lenders. The purpose of YSP is two-fold. Firstly, it incentivizes brokers to arrange loans at higher interest rates than the lowest rate a borrower could potentially qualify for.
Secondly, it can facilitate borrowers who lack the upfront funds to cover closing costs. In this case, it enables borrowers to finance those costs over the life of the loan by accepting a higher interest rate, and the yield spread premium is offered to the mortgage broker as a sort of commission for arranging this type of loan. Yield Spread Premium sees its application predominantly in originating new loans or refinancing existing ones.
Mortgage lenders utilize this tool to adjust interest rates according to the lender’s risk levels and profit margins. Under the model, a broker may offer homebuyers an option to pay less upfront for their mortgage during closing, with the understanding that the interest rate would be slightly higher over the life of the loan. This process may make the mortgage more accessible to borrowers, but it may result in higher overall costs in the long term.
Examples of Yield Spread Premium
Mortgage Lenders: If a potential borrower meets a mortgage lender to discuss a loan of $200,000, the lender might offer an interest rate of 5%. The lender also tells the borrower they can lower the interest rate to5% if they pay another point up front. This up-front point is also known as a Yield Spread Premium or YSP. It is an additional cost to the borrower to help them secure a lower interest rate.Refinancing: Let’s say a homeowner is looking to refinance their mortgage. The broker tells them they qualify for a loan at
8% interest rate. Unbeknownst to the borrower, the lender had actually approved the loan at a5% rate. The broker, however, is permitted to quote higher rate and hence quotes8% to the borrower. The difference in the extra interest that the borrower pays over the life of the loan (
8% vs5%) is the yield spread premium, which is collected by the broker.Auto Loans: An auto dealer might offer a potential buyer financing at a certain rate. The dealer has a relationship with a lender who actually provides the loan. They may have qualified the buyer for a loan at a
5% rate but tell the buyer the rate is 4%. The difference in the interest over the life of the loan is the yield spread premium, which is usually kept by the auto dealer or split with the lender. This is much less common since laws governing the practice vary by state and by type of loan.
Frequently Asked Questions on Yield Spread Premium
What is Yield Spread Premium?
Yield Spread Premium (YSP) is a form of compensation that a mortgage broker, acting as the intermediary, receives from the original lender for selling an interest rate to a borrower that’s higher than the lender’s par offering rate.
How is Yield Spread Premium calculated?
Yield spread premiums are calculated as a percentage of the loan amount. The higher the interest rate above the par rate that the broker sells, the higher the percentage of the YSP.
Is Yield Spread Premium legal?
As of 2011 with the enactment of the Loan Officer Compensation rule under the Dodd-Frank Wall Street Reform and Consumer Protection Act, yield spread premiums are no longer legal in certain types of loans. It is considered a conflict of interest for brokers to receive compensation for directing consumers towards more expensive loans.
What is a negative Yield Spread Premium?
A negative yield spread premium occurs when the mortgage broker gives the borrower a loan at a lower interest rate than the par rate. In this case, the borrower pays an upfront cost to the broker to buy down the rate, also known as discount points.
Related Entrepreneurship Terms
- Mortgage Broker
- Interest Rate
- Loan Origination
- Financial Compensation
- Refinancing
Sources for More Information
- Investopedia: A reliable source for understanding finance and investment terminologies. Detailed information about Yield Spread Premium can be found through their search feature.
- Consumer Financial Protection Bureau (CFPB): A U.S. government agency that makes sure banks, lenders, and other financial companies treat consumers fairly. Useful information on Yield Spread Premium can be found in their database.
- Nolo: A site that provides free legal and financial advise to consumers. Their database includes information on a wide array of topics including Yield Spread Premium.
- BankRate: A consumer financial services company that’s an authority in personal finance. Information on topics like Yield Spread Premium can be searched on their website.
