Vision Credit Education, Inc.

Before one can understand what a yield spread premium, or YSP, is, it’s important to be familiar with a yield spread. In consumer loans, a yield spread is the difference between the percentage rate a consumer actually pays on a loan and the percentage rate that consumer’s credit allows them to pay on that same loan. For example, if a consumer pays a rate of 6.75% on a loan but has good enough credit to only pay 6.25% on that loan, the yield spread for that particular loan is 0.5%.

A YSP is the cash rebate a lender pays to a broker that sells an interest rate above that which the borrower qualifies for. In the example mentioned before, the broker would be eligible for a YSP from the lender because s/he was able to sell a loan to a borrower at a higher interest rate, which means the lender will be making more money on that loan than it normally would.

Now, why would a borrower agree to pay a higher interest rate? Sometimes, it’s worth it to the borrower to pay a slightly higher rate because the deal found by the broker is better than any the borrower could have found on his or her own. A broker can be extremely helpful with all the confusing paperwork, like the loan applications. Also, some brokers will waive expensive up-front costs that are usually associated with signing for a loan, especially for mortgages. Such costs include the title search and insurance, legal fees, processing costs, etc. The broker will account for these “waived” fees by increasing the yield spread, which increases the YSP s/he will receive from the lender. In this case, the borrower pays less up-front but winds up paying more every month due to the higher interest rate. If the borrower plans to hold the loan longer than three or four years, s/he usually ends up paying more in the long run. However, this may be the best option for those borrowers who cannot afford such expensive up-front costs.

There are several dangers to YSPs. First, they tempt brokers to inflate the yield spread on a loan because that means higher profits for themselves. Second, if a lender must pay the broker a YSP, the lender wants to make sure that it benefits from that higher interest rate completely. So, the lender will encourage brokers to steer borrowers into agreeing to large prepayment penalties. This way, even if the borrower pays the loan off early, the lender will be able to recoup that YSP paid to the broker by way of a large prepayment penalty from the borrower.

Consumers can protect themselves from YSP abuse. First, understanding that this practice exists among lenders and brokers will help a consumer spot any abuses. Carefully comparing APRs is an easy way to evaluate a loan. Due to the Truth in Lending Act (TILA), information like that must be clearly disclosed by any lender in the terms of the loan (watch the fine print). Finally, hiring a credible broker will greatly reduce the risk of YSP abuse. Requesting references or using a recommendation from a friend are ways of getting in touch with a responsible broker.