New Good-Faith Estimate Would Help Rein In Closing Costs

Last week I reported favorably on one part of HUD's reform proposals. A new and substantially improved good-faith estimate would make it easier for borrowers to shop for loan providers. The proposed estimate, along with new rules on how it must be used, would also eliminate critical weaknesses of the current estimate that encourage opportunistic pricing -- the practice of charging you as much as they can get away with.

The current good-faith estimate is an open-ended list of settlement costs with no meaningful subtotals, encouraging lenders to invent new charges. Further, all of the charges are "estimates" subject to change, the only barrier to abuse being the "good faith" of the lender. In all too many cases, charges are raised in bad faith, and there is nothing the Department of Housing and Urban Development can do about it.

On the proposed estimate, settlement costs are divided into three categories. Category one includes all charges by the lender and mortgage broker, tabbed "Our Service Charge," and government recording and transfer charges. At settlement, these charges must be the same as those on the good-faith estimate. This rule is completely appropriate regarding the lender's own charges; it is also long overdue. Charges by governmental entities are another matter, and my experience suggests that these charges belong in category two, where the loan provider has a little latitude.

The second category would consist of services provided by entities selected or identified by the loan provider. The most important of these is title insurance. The total of such charges could be as much as 10 percent higher at settlement than shown on the new estimate. This limit is better than no limit, but it doesn't touch the dysfunctional system that makes third-party settlement services far more costly than they should be.

The third category is for services that the borrower has elected to shop among providers not selected or identified by the loan provider. It includes homeowners insurance, which borrowers typically buy on their own, and it can include title insurance if the borrower solicits title agencies on his own. These charges are not subject to limits on price increases. This is a reasonable exemption.

To help borrowers police their own transactions, HUD has proposed to change the HUD-1 closing document so that it corresponds closely with the new good-faith estimate. It will then be easy for borrowers to compare the final charges on the HUD-1 with those on the estimate. Good idea.

HUD also intends to seek authority to require that the HUD-1 form be made available three days before closing, rather than one day, the current requirement. Another good idea, but it ought to include the mortgage note in this requirement. There is no excuse for forcing borrowers to confront a complicated contract for the first time at the closing table.

The most disappointing part of the proposed good-faith estimate is that it leaves untouched the odious network of relationships between loan providers and third-party service providers, which raise the cost of these services to borrowers. Mandating that a title charge of $1,000 on the good-faith estimate can't be more than $1,100 on the HUD-1 closing document doesn't accomplish much if the charge ought to be $300.

Although it is not possible to know what the charge would be in a properly functioning competitive market, we do know that the perversely competitive markets we have now encourage high prices. Competition is perverse when service providers market not to purchasers but to the entities that refer the purchasers to them. The loan providers who refer mortgage borrowers to third-party service providers share in the overcharges -- sometimes legally, sometimes not.

The remedy is well-known and well-tested. It is to require lenders to pay for all services that they require from borrowers. If lenders want title protection, they should buy it and pay for it, passing the cost to borrowers in the rate and points. The cost passed through would be a small fraction of what borrowers pay now, as lenders are large and knowledgeable purchasers that can buy in bulk.

This is not a pie-in-the-sky idea. Indeed, since Bank of America adopted it last year, it can be viewed as an industry "best practice." Yet HUD, despite its legal mandate to lower settlement costs, ignores it. If this reflects HUD's concern that it will receive no support, it is surely mistaken. If the idea were placed on the table, community groups would have to support it. How could they not?

To be sure, mortgage bankers would oppose the idea because trade groups can't advocate best practices without alienating a major segment of their membership. But the fact that a leading lender has adopted it voluntarily and successfully will make it difficult for them to argue that the market will collapse.

Next week: How broker charges would be handled in the new good-faith estimate.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http://www.mtgprofessor.com.

© 2008 Jack Guttentag Distributed by Inman News Features