Yield Spread Premium

A Yield Spread Premium (YSP) is offered to a mortgage broker as compensation. It is computed as the difference between the par rate and the actual interest paid by a home mortgage borrower.

Lenders can either award the YSP to the broker for quoting an interest above par rate or utilize the YSP for beating underlying costs—associated with the mortgage. Despite being a common practice in home mortgages, YSP increases the financial burden on borrowers. Most ‘no-cost’ loan offers to include YSP, but borrowers are unaware of the extra interest.

• A yield spread premium definition is the extra interest paid by a borrower over the par rate set by a lender. For example, mortgage brokers quote a higher price than market rates. The difference acts as compensation for the broker.
• The Dodd-Frank Financial Reform Bill was released in 2010 in the US to protect borrowers from exploitation. The Bill put an end to YSP.
• YSP is calculated as follows:
  YSP = Quoted Interest Rate – Par Interest Rate) × Mortgage Loan Amount.

When buyers look for a home mortgage deal, they have two options—find a lender directly or approach a mortgage broker. Hiring a mortgage broker does save a lot of time; the buyer might even get a better deal this way. On the downside, the buyer hiring a broker might end up paying higher interest in the form of a YSP. The YSP compensates mortgage brokers for their time and efforts.

Brokers mediate deals and, in lieu, charge higher interest on mortgages (higher than market rates). It is computed as the difference between the actual interest rate charged from the borrower and the market interest rate (also known as the par rate). 

Of course, brokers deserve a cut for their efforts. The problem arises when borrowers are kept in the dark. Borrowers are not always aware of such additional charges, and the brokers rarely try to come clear. This is especially the case with the origination fee. As a result, borrowers end up paying more than they anticipated.

Again, more would opt for the direct approach if borrowers were privy to such details. Borrowers are highly recommended to conduct due diligence and determine such hidden costs. This way, borrowers can avoid no-cost mortgage schemes, which are significantly costlier in the long run. Borrowers are better off paying a one-time fee than extra interest throughout the loan.

Also, brokers do not always end up benefitting from YSP. Often, mortgage lenders use the excess interest to pay off loan-related costs. Such costs are disclosed at the closing in a HUD-1 form.

Moreover, in 1999, legislation was passed to disregard YSP—in an attempt to safeguard borrowers from exploitation. Similarly, during the post-financial crisis of 2007-08, YSP was banned in the U.S. The Dodd-Frank Financial Reform Bill was passed in 2010—to protect real-estate customers from exploitation.

Let us look at some yield spread premium examples to understand the computation of YSP.

Example #1

Let us assume Philip is a mortgage broker, and XYZ Ltd. is a mortgage lender. The broker quotes an interest rate of 6.55% on a no-cost mortgage loan worth $160,000. Bethany is the borrower.

If the lender’s par rate is 5.7%, determine the mortgage Yield Spread Premium (YSP) received by Philip as compensation.

Solution:

Given:
Par Interest Rate = 5.7%

Quoted Interest Rate = 6.55%

Mortgage Loan Amount = $160,000

YSP = (Quoted Interest Rate – Par Interest Rate) × Mortgage Loan Amount.

YSP = (6.55% - 5.7%) × $160,000 = 0.85% × $160,000 = $1360

Thus, Philip will receive a YSP of $1360 as compensation.

Example #2

Let us look at an alternate scenario. The broker (Philip) offers a loan deal to Bethany where she pays an origination fee of 1%. This is in addition to the 5.7% interest (par rate) on the mortgage loan (worth $160,000).

Now, based on the given values, ascertain the compensation received by Philip in the form of origination fees.

Solution:

Given:
Par Interest Rate = 5.7%

Origination Fee = 1%

Mortgage Loan Amount = $160,000

Origination Fee = 1% of Mortgage Loan Amount

Origination Fee = 1% × $160,000 = $1600

Thus, Philip receives $1600 as compensation from origination fees.

Example #3

Let us consider another example.

Stanley is a mortgage broker. He quotes an interest rate of 7.25 % on a no-cost mortgage home loan worth $300,000. On top of the interest, Stanley charges an origination fee of 1%. Ralph is the borrower.

The lender’s par rate in this scenario is 6.5%, but the YSP will be utilized to meet upfront costs. Based on the given values, determine the YSP, origination fee, and the total amount Ralph (borrower) paid.

Solution:

Given:
Par Interest Rate = 6.5%

Quoted Interest Rate = 7.25%

Mortgage Loan Amount = $300,000

Origination Fee = 1%

YSP = (Quoted Interest Rate – Par Interest Rate) × Mortgage Loan Amount.

YSP = (7.25% - 6.5%) × $300,000 = 0.75% × $300,000 = $2250

Origination Fee = 1% of Mortgage Loan Amount

Origination Fee = 1% × $300,000 = $3000

Thus, the total amount to be paid by Ralph is:

YSP + Origination Fee = $2250 + $3000 = $5250

Also, Stanley receives $3000 as compensation for his efforts. The lender keeps the YSP, an amount of $2250, and uses it to pay off loan-associated costs.

This article is a guide to what is Yield Spread Premium & its definition. We explain mortgage yield spread premium with examples. You can learn more about corporate finance from the following articles -

• Interest-Only Mortgage
• Mortgage Originator
• Fixed Interest Rate