Section 2.2 on page 70 of the Royal Commission Final Report says:
“The chief value of trail commissions to the recipient, to put it bluntly, is that they are money for nothing. Why should a broker, whose work is complete when the loan is arranged, continue to benefit from the loan for years to come?”
Recommendation 1.3 says:
“The borrower, not the lender, should pay the mortgage broker a fee for acting in connection with home lending.”
The Royal Commission has certainly put a blowtorch on the practices of some of our banks and financial institutions but that was hardly a revelation. Many people, including myself, have been writing about them for years. Default interest on loans in arrears and shonky insurance policies for credit cards are just two examples.
But the blowtorch is particularly hot on one section of the industry: mortgage brokers, who account for over half of all residential home loans settled.
Mortgage brokers and payment preferences
The proposal to ban trail commissions for mortgage brokers concerns me. While this has been welcomed in certain sectors, there is a general ignorance of the purpose of trailing fees and how they work. It’s a quirk of human nature that most people have no problem with expenses that are deducted but hate to receive a separate invoice. The classic case is the group certificate and personal income tax. Nobody seems to worry when $20,000 is deducted in tax, but they will scream if they are asked to write a cheque for $500 to the tax man.
When the financial services industry was in its infancy, the main remuneration was by an upfront commission. The problem with this was that the business had no recurring income and was solely dependent on chasing new business just to stay afloat. This also created the problem of how to charge a person who wanted ongoing advice from time to time.
It was unsustainable and eventually upfront commissions were cut and a trail fee introduced in lieu. This gave the business a basic income to rely on, while enabling it to provide ongoing service to their clients without issuing a new invoice. This is a different model to say a law office who will charge up to $49 just to open an email.
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I received a great insight into the mortgage broking business last month when I was researching borrowing for the family home. The options were overwhelming, the criteria for loan eligibility were inconsistent and confusing, the loan rate varied from lender to lender and the pick for the most suitable lender often turned on whether the borrower could meet certain eligibility criteria. My conclusion was to go to a mortgage broker – it’s too hard to do it on your own.
The mortgage broker told me that on a $400,000 loan, he would receive an upfront commission of 0.6% or $2,400 paid for by the bank. It could be clawed back if the loan was paid out within three years from establishment. The lender would pay the broker a trail fee of 0.15% or $600 a year as compensation for providing advice to the borrower as needed.
This could include advice about moving to a fixed rate, managing a change of employment or a move interstate by the borrower, negotiating a better rate with the existing lender instead of changing banks, and checking the best way to finance a change in residence or the acquisition of an investment property.
What might happen now?
The Royal Commission has recommended that this system be scrapped, including both upfront and trail commissions. Applicants who wish to use a mortgage broker will have to pay an upfront fee, and if they can’t pay, it could be added to the loan!
Well, you know what’s going to happen. No young couple looking for a loan will be prepared to fork out over $2,000 to a mortgage broker to research the market and find out the best deal. Instead, they will go online to look for what appears to be the best deal and jump in.
The banks will have a field day. Without a mortgage broker as an intermediary to keep them honest, the hapless borrower will be at their mercy. Expect a return to establishment fees and even more complex products.
When the Royal Commission was taking place the values of bank shares were slashed. It speaks volumes that as soon as the market opened after the release of the Final Report, bank shares were up around 5%. I rest my case.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance, which can be found on his website noelwhittaker.com.au.