The next refi boom’s double-edged sword: EPOs

Shannon Hoff, a California-based branch manager at American Pacific Mortgage (APM), finds herself both enthusiastic and cautious as she assesses the prospects of the mortgage market in the coming year.

After two of the most challenging years in recent history, economists and analysts project a shift in the mortgage market toward the end of 2023, Hoff said. 

“Lenders and loan officers right now are just in survival mode,” Hoff said in an interview. “But economists said mortgage rates should be in the 5s in the first or second quarter of 2024.” 

Over the past two years, Hoff and her branch have dealt with declining mortgage volume. About 20 loan officers under her leadership produced $116 million in mortgages over the last 12 months, a drop from $223 million in 2022, according to the mortgage tech platform Modex. Roughly 85% of the transactions over the past year were purchase mortgages, the data shows.  

When the market turns, more refi opportunities will emerge for Hoff’s team. But it will bring with it different challenges. 

Hoff is referring to the need to retain borrowers in a competitive refi environment and to develop strategies to avoid early pay-off (EPO) penalties. Investors impose these fees on lenders whenever a borrower pays off their mortgages usually within up to six months of funding. In turn, lenders charge branches and LOs, sometimes taking their commissions back.

These issues are not affecting the current market, where high rates have reduced the refi mix to about 10% of originations pie. Hoff, however, is taking steps to avoid future problems.

“For my clients, if rates do get into the 5s, we’re going to jump in [to originate refis]. “I’m a relationship maker. And that’s what will help me with EPOs.” 

HousingWire spoke to lenders and loan officers to understand their expectations for the mortgage market and, ultimately, their strategies in a refi environment to retain borrowers and mitigate EPO penalties.

When will the market turn?

Let’s start with the good news. The 30-year fixed-rate mortgage, which reached 7.17% on Monday at HousingWire’s Mortgage Rates Center, will decline at some point. This shift mirrors the cyclicality of the mortgage market and the expectations that the Federal Reserve will soon be done with its monetary tightening to combat persistent inflation. 

Several housing industry economists believe rates will drop into the 6s sometime in the fall. The latest forecast from the Mortgage Bankers Association (MBA), which is more optimistic, showed the 30-year fixed rate to end this year at 6.2% and the second quarter of 2024 at 5.6%. Meanwhile, economists at Fannie Mae expect rates to end 2023 at 6.7% and 2024 at 6%.  

When rates drop, the pipeline of purchase transactions of 2022 and 2023 will be in the money for significant savings through refinancings, mortgage industry leaders say. 

“Something I feel like folks do underestimate is: this year, there’ll be $1.5 trillion or $1.7 trillion of mortgages produced, and all those mortgages will be at a higher coupon. And at some point, all those mortgages will be back in the money [for refis]. And people underestimate how much rates have to move to make that beneficial for the clients,” Brian Brown, Rocket Companies chief financial officer, told analysts during an earnings call in August. 

Brown added: “We’re originating mortgages every day at these prevailing rates and higher coupons that it only takes a few-basis-point move to be back in the money [for a refi] and make it beneficial for those clients.”   

One sign of forthcoming refi opportunities is the encouragement by mortgage originators for borrowers to find the “dream home,” securing a mortgage at higher rates but refinancing in the near future. It follows the popular saying: “Marry the house, date the rate.”

“A lot of mortgage originators are having those conversations: ‘Listen, we’re gonna put you in this home because you found it in this tight inventory market. You find a dream home, let’s lock you into that dream home today, and we can refinance you when that rate comes down.’ So when that happens, ultimately, all those customers that you did transact that purchase will be eligible for refinance,” said Dan Catinella, chief lending officer at Total Expert, a provider of CRM platform to mortgage companies. 

Catinella said we will see a trend down in mortgage rates towards the end of 2023, hopefully to the low 6s. However, he pointed out that the longer the heightened rate environment persists, the more opportunities for refis will emerge when rates decline.  

“Ultimately, that pipeline of purchase transactions that you did over the last six-to-nine months are all going to be in the money for a significant amount of savings… Typically, from a lender’s standpoint, it’s between half a point to three-quarters of a point when they start to have those conversations about refinancing with borrowers. That’s when it starts to present a real net tangible benefit to the consumer.” 

Ready for the EPOs?

However, a refi environment may trigger EPO penalties, loan officers and lenders told HousingWire. After a loan is funded, the lender usually sells it to an investor who pays a price expecting a long-term return. If the borrower pays the loan within a few months, the investor’s return will not materialize. 

EPO fees serve as a means for investors to recoup a portion of their initially projected returns. These penalties are usually imposed on lenders when the borrower pays off their loans within four to six months after taking them out, but in some cases it can be up to one year. In turn, lenders charge their branches and/or loan officers with the EPO penalties, depending on the company’s structure. 

In this case, lenders need to be careful, attorneys say. “A lot of lenders have to rewrite their compensation arrangements to make clear that you don’t earn the commission when the loan closes; you earn it when the early payoff period ends three to six months after closing,” Richard Andreano, practice leader of Ballard Spahr’s mortgage banking group, said.   

Virginia-based lender Alcova Mortgage, which has 75 branches and 178 loan officers, according to Modex data, doesn’t charge loan officers. “But the branches are charged into their profit and losses, so they want to try to avoid it as much as possible,” co-founder Bobby Nicely said. 

EPO penalties can easily be up to 3% of the individual loan pricing, translating into thousands of dollars in most cases, Nicely said. Some lenders negotiate these fees with investors when the loan is delivered to them after the refi transaction. 

Nicely also pointed out that recent regulatory changes have helped lenders avoid these penalties by requiring borrowers to wait before refinancing their loans. In these seasoning requirements, authorities are concerned about repeated refis – basically, if the lender is helping or hurting borrowers with the transactions. 

“One thing that helps a little bit on the government loan products is that Ginnie Mae made a few changes years ago where borrowers have to make six payments before they are eligible [for a refi],” Nicely said. 

In the realm of cash-out refis, Fannie Mae and Freddie Mac introduced rule changes in 2023, stipulating that borrowers must wait 12 months to get new cash outs after purchasing a house, getting a rate-and-term, or getting a cash-out refi.

During the last refi boom in 2020 and 2021, there was an elevated level of loan churning, when LOs solicited a borrower to refinance with little to no financial benefit but additional costs and fees. The practice drew the ire of lenders, who went after LOs. Some lenders accused LOs of encouraging faster refinancing than the entire market driven by higher individual compensation plans. Lenders accused LOs of potentially charging the borrower a higher rate initially to set up a refinance later on. 

Thus far, EPO penalties haven’t been a pressing concern in a purchasing environment. The Mortgage Market Opportunities Report by TrustEngine, which reviews data from more than 150 residential mortgage lenders, shows that in the second quarter of 2023, only 0.23% of borrowers qualified and could benefit from the current interest rates for a refinance. Regarding the EPO risk, the survey shows that only 1% of customers whose loans closed less than six months ago have shopped with a competitor, which could trigger penalties.  

But in the next refi boom, EPO penalties will be top of mind. And many lenders are still recovering from the current depressed market.

Much of the EPO concern can be traced to the industry’s poor retention rate, which is about 20%, according to experts. In a hypothetical scenario, let’s say 300 out of a lender’s 1,000 borrowers refinance with another lender. A typical EPO penalty can cost the lender between 3% to 5% of the loan amount, or about $10,000 on a $340,000 loan, meaning they’re looking at a combined $3 million hit, Catinella said. 

Industry experts anticipate that lenders who sold their servicing portfolio during the compressed mortgage market may face greater challenges. That’s because whoever services the borrower has a competitive advantage in terms of retention. 

“In the second quarter of 2023, we were profitable as our servicing portfolio helped us tremendously. But, if not managed properly, EPOs can have a tremendous negative effect,” Nicely said. Alcova maintains a portfolio of 11,000 loans in its servicing book, he added. 

Blake Bianchi, founder and CEO of Idaho-based lender Future Mortgage, is concerned with EPO penalties. He recently negotiated with investors to exempt his company from these penalties if his company sells more loans to these investors as a preferred partner. 

“One of the main concerns for me as a business owner, and also the loan officers, is that everyone’s already living paycheck to paycheck and having a hard time,” Bianchi said. “Imagine me as a business owner having to go back to the loan officer and say: ‘We need your commission back for the last two months or whatever. That puts me in a really bad position. We’re gonna try to increase our business with them because they’re looking out for us as well. It’s a win for everyone.”

Max Slyusarchuk, CEO of the non-QM lender A&D Mortgage, believes that EPOs are not a significant issue because it is rare that a borrower completes a loan and then pays it off in under six months. While mortgage rates can drop, they generally don’t move quickly enough to create an issue within six months, he said.

However, Slyusarchuk said that A&D Mortgage may consider eliminating EPO penalties for preferred partners. “So, if you are a preferred partner, you won’t have to pay. But if you are not, we’re still going to keep EPO [penalties]. It would be part of our loyalty program,” Slyusarchuk said.

What is your retention strategy? 

Andreano said rates will drop from the current levels, whether next year or 2025. Lenders should look at their investor policies before applying retention initiatives.  

“Some lenders are now telling the consumer: ‘If you come back to me for a refinance, I’ll give you this good deal.’ If you’re going to do that, though, you have to check your master policies because I know some investors call it a pre-arranged refinancing. And Fannie Mae, for example, won’t buy the loan you’re making now until it’s a negotiated deal.” 

Andreano also pointed out that usually, investors have in their agreements that lenders are not allowed to solicit the consumer for a refinance for a period because they don’t want to have to keep buying the loans over and over again. If investors start seeing a lot of refis from the same lender, that’s a red flag. 

“It’s when rates fall slowly that you have many repeated refinances. That’s where you get many issues with regulators and investors. If rates drop quickly, you may only get one or two refis per borrower. And that’s not going to present the issues as much.” 

Hoff, the branch manager at APM, has embarked on a mission to retain her borrowers. She’s rolled out a series of initiatives, including “rate alerts,” which show when her borrowers are eligible for a refi. She is also enrolling borrowers in “opting out” of receiving prescreened offers from other lenders and LOs. 

Hoff said borrower retention has been discussed over the past month at APM in Roseville and its community. 

“We’re actually in communication with our secondary on what they can do because we have certain investors that the EPO penalties are four months, certain investors that it’s six months, certain investors it’s eight months, so we’re trying to jump on this challenge right now and figure out what we can do. We’re at the forefront in communication with this, trying to find a solution.”

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