APRIL 2004

Disclosures Increase Confusion

More information is not necessarily a good thing. The Federal Trade Commission (FTC) has found that a proposed new disclosure on mortgage transactions would actually do more harm than good. The disclosure involves information about the way that mortgage brokers are compensated by the lender. Apparently, disclosing to consumers that a broker’s compensation was tied to the interest rate on the loan biased consumers away from choosing brokered loans, even when the numerical disclosure of rates indicated that the broker-generated loan was cheaper for the customer.

Compensation to brokers is often in the form of a yield spread premium (YSP), an amount paid to the broker by the lender for loans that are made at interest rates above the minimum that the lender would accept and still make the loan. Many in the mortgage industry have argued that payment of a YSP is a useful tool for giving brokers an incentive to work harder to generate loans. Consumer advocates counter that YSPs give brokers an incentive to steer borrowers toward higher cost loans. Acknowledging elements of truth in both claims, the Department of Housing and Urban Development incorporated new disclosures of YSPs into its proposed reforms to the Real Estate Settlement Procedures Act (RESPA). Among other new disclosure rules, HUD proposed that any compensation provided to a broker by the lender be disclosed in the Good Faith Estimate provided to borrowers. However, a loan made at the very same interest rate, but directly by a lender without going through a broker, would not face a similar disclosure.

Suspecting the potential for confusion, the FTC conducted a controlled experiment with 500 recent mortgage customers. Participants were shown cost information about two hypothetical mortgage loans and asked to identify which loan was less expensive and which they would choose if they were shopping for a mortgage. As part of the cost information, some of the participants received disclosures that presented various versions of the HUD proposal, with one of the two loans being identified as a brokered loan and an indication of the YSP amount for the brokered loan. The remaining participants received no information regarding YSP or broker compensation.

In the groups that did not receive any information about broker compensation, about 90% of respondents correctly identified the less expensive loan, and between 85% and 94% indicated they would choose the less expensive loan if they were shopping for a loan. In contrast, in the groups that were shown the additional information on broker compensation, only 63% - 72% of the respondents correctly identified the less expensive loan, and only 60% - 70% indicated they would choose the less expensive loan. Moreover, 16% - 27% identified the more expensive loan as the one they would choose. FTC economists James M. Lacko and Janis K. Pappalardo concluded in their report that HUD’s proposed broker compensation disclosure "is likely to confuse consumers, cause a significant proportion to choose loans that are more expensive than the available alternatives, and create a substantial consumer bias against broker loans, even when the broker loans cost the same or less than direct lender loans." The FTC report is available by following this link.