Blog > Posts from January 2008

After three days of fielding press and industry-insider interviews, I have a new perspective on people's knee-jerk reaction to what we are doing. Now, keep in mind that these are, by definition, the most jaded and cynical questioners with regard to new business models in the real estate arena. They know all the ways people have tried to skin the cat, and they assume we fit into one of the pigeonholes they've created.

The greatest skepticism was reserved for our Free Mortgage. The assumption is that this is done with smoke and mirrors. Partly, this is due to the way traditional brokers have used ABA and in-house mortgage companies to abuse their customers--making extra money from them in the name of "one-stop shopping". So there is a tradition in the industry of using mortgage as a sneaky way to make money and pad the bottom line.

Second, mortgage is such an easy thing to play numbers games with. It's like a balloon--squeeze on the rate and the points increase; squeeze on the points and the "fees" increase. Anyone can offer a "no closing cost" loan (if you don't care about the rate). Anyone can offer a super-low rate (if you don't care about points and fees).

So, I wanted to address this issue directly: What makes our Free Mortgage legit? How can our buyers really get a well-below-market rate AND pay no closing costs?

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It's finally here. For months, we have been working towards launching our business and site at the end of January, and we made it. It is a strange feeling to switch from keeping things under wraps to trying to tell everyone at once—a complete 180 in a single day.

Yesterday, we sent a preview link out to select members of the media, focusing on real estate, technology and DC-area business news outlets. We got a very good response to both the site and the business model, which was really gratifying. When you work on something new for the better part of a year, it is hard to keep perspective on it, despite constant attempts to challenge your own assumptions and previous thinking. So it is nice to see that after being in the bunker for a long time, our business makes sense to some real people who are seeing it for the first time.

Last night, one real estate technology blog got a little ahead of us and sent our press preview link out to the world. We'll forgive them since it was in the course of a pretty nice review of what we're doing. So last night, instead of the few dozen reporters, hundreds of visitors started showing up. Rather than one last decent night of sleep, we stayed up to be sure everything worked as planned. And to satisfy our curiosity about what people would do once they got there.

As expected, the big draw was our map-based home search. Some people used other pieces of functionality, or checked out the more texty bits of the site. But most people spent their time on the map—several for over an hour!

Today we will open the doors for real, and hope to see an even larger audience. It's a big shift to go from a secret to a real business in one day. We'll see how it goes.

Throughout development of our search technology, usability has been at the top of our list of priorities. We wanted to make something that regular people could actually use to find and evaluate homes. I pictured my parents using the site. Could we make it easy for them to understand and navigate while still maintaining the powerful search features? Turns out I was off by two generations.

Last night, I was using the site on my computer at home, putting it through its paces a few days before our public launch. I left it open to our main search page and was called away for a while by my younger son. When I returned, I found his brother, five years old, reviewing and rating properties—dozens of them.

Holding my laughter in, I watched quietly as he clicked on each little “X” icon, opened the “View Complete Listing” page, clicked the “View All Pictures” link, and reviewed each home to determine the number of ceiling fans it had. If it had a lot, it got four stars; fewer got two or three. He quickly gave listings with no pictures one star (like any buyer would!).

I did have to show him how to scroll the map around, but that was about it. And once I told him the “My Favorites” link collected all the three- and four-star listings, he was psyched. But he got the basic idea without any adults around—he even put the site in his Favorites in Internet Explorer. Our first fan.

Hopefully, this means my parents will be OK too. And everyone else.

As housing prices (and commissions) leapt up over the last few years, the number of real estate agents skyrocketed. Today, there are over 2.77 million of them—one in every 79 adults is a licensed real estate agent! (In fact, it’s much higher than that in areas with higher home prices.)

But as the number of agents has grown, the experience of the average agent has plummeted. The vast majority of these agents haven’t been in the business that long, operate part-time, and don’t do that many deals each year.

Increasingly, real estate brokers have focused their attention (and marketing) on bringing in as many of these low-volume agents as possible. They pay them significantly lower commission splits than top agents and are more likely to get business for their high-profit mortgage and title companies. (Top agents and teams often shy away from the in-house lender and ABA settlement company.)

The idea is that these new agents will sign up their friends and family when they’re ready to buy or sell. And guess what…it works. But that doesn’t mean it’s a good system.

These brokers want you to make a subjective, personal decision in picking your agent—more like deciding who to invite to your party. Who do you already know? Who will be offended if you don’t pick them? Who do your friends like best?

Sawbuck is trying to do things differently. We want to help buyers find an agent for better reasons. Who has the most experience in this neighborhood? Who can provide unique insight into the homes you like? Who has the best chance to know that a house you’ll love will hit the market next week?

You might be surprised to find out that most of their revenue comes from selling title insurance, not from "settlement fees" or other charges. In addition to their other roles, settlement companies are also "title insurance agents"—they sell title insurance policies issued by larger title insurance companies. In fact, 80-85% of the cost of the title insurance policy goes to the settlement company; only the remaining 15-20% goes to the insurance company who issues the policy.

Especially in areas with higher home prices (which mean higher title insurance costs), this is by far their largest source of revenue. So, even if they didn't charge a single other fee, they are still making money.

But they do charge other fees. Sometimes lots of them. That's how you get the settlement fee, title examination fee, doc prep fee, binder prep fee, courier fee, notary fee, attorney's fee, release procurement fee, wire fee, payoff fee, copy and fax fee, tax cert fee, and release recordation fee, to name a few. They're just different ways of saying "additional revenue for the settlement company."

Now, some of the fees charged by settlement companies are just passed through from another company. The cost of the title search or survey (both necessary to buy a house) gets passed on to the companies that perform those services. This isn't revenue to the settlement company—unless they mark it up!

Most people know they need to get title insurance when they buy a home, but aren't sure what it is or why they might need it.

Title insurance ensures that the abstractor and title company have done their jobs correctly in perfecting title to your new property. In fact, the reason so much of the premium goes to the title company is that they do all the work ahead of time to make sure there never is a claim. It also insures against title issues they couldn't know about. In short, title insurance gives you (and your mortgage lender) confidence that you really do own the house you just bought. (For more details on title insurance, visit Wikipedia or the American Land Title Association.)

In most states the cost ("premium") for title insurance is filed with the state. That means that for a given purchase price, all buyers will pay the same amount, no matter which settlement company they use. Settlement companies can't mark up or discount the premiums they charge.

"Enhanced" Coverage

Still, in recent years the title industry did invent a new way to make more money on title insurance. They created "enhanced" coverage. While it does offer some additional protections, the primary "enhancement" is that it costs about 20% more than what is now called "standard" coverage. (Just ask any title attorney if they paid for "enhanced" coverage on their last home purchase.)

Increasingly, settlement companies default to selling enhanced coverage unless buyers specifically ask for the standard policy. This is another way settlement companies make more money.

Strange as it may sound, in recent years, large real estate brokers make less and less of their money from real estate. To compete for agents, they've had to gradually increase the "split"—the percentage of the commission that stays with the agent. Agents keep more; brokers keep less.

To compensate for this lost revenue, these brokers have turned to "ancillary services" (i.e. mortgage, settlement, insurance, etc.) to pump their profits back up. Many brokers now make more on these other services than on real estate itself.

Because these "ancillary services" are so important to the bottom line, agents are pressured in subtle (and not-so-subtle) ways to direct their customers to the in-house mortgage company. Needless to say, the in-house loan officer feels little need to be aggressive in quoting rate, points and fees. They know most of these customers are "in the bag" due to the trusted agent's recommendation—they aren't going to shop.

For these large brokers, real estate is becoming a loss leader designed to sign up as many buyers as possible, who in turn feed their mortgage and title profit centers.

Between 1980 and 2000, power shifted from real estate brokers to real estate agents. Now, brokers must compete harder to attract and retain their agents. To do so, they have steadily increased the "split"—the portion of the sales commission the agent keeps. As brokers earn less and less on real estate, they have looked for other ways to make money.

Enter the ABA

In an Affiliated Business Arrangement (ABA), the real estate broker and settlement company form a third, jointly-owned company that becomes the title insurance agent. The settlement company still does the same work they would do for any settlement, but the title insurance policy is issued through the jointly-owned company. That company then keeps 80-90% of the premium (see How Settlement Companies Make Money). This revenue is split between the two owners of that company—the real estate broker and the settlement company.

The net result is that the settlement company just gave half of its largest source of revenue back to the real estate broker—a legal kickback. They do it to guarantee a steady stream of business from that broker and their agents. But it also means they have to make up for that lost revenue.

Bring on the Fees

Settlement companies with ABAs have to charge higher fees—settlement fees, title examination fees, doc prep fees, binder prep fees, courier fees, notary fees, attorney's fees—because they're only making half as much on title insurance, while doing just as much work.

Now, none of this would work if the broker's agents weren't asked to send their customers to the settlement company with the ABA. And that's what happens. Unless the buyer specifically objects (and how would they know to object?), the deal often goes to the ABA by default.

While these ABAs are specifically structured to stay within the bounds of the law, they are typically bad for buyers, and increasingly under scrutiny by regulatory agencies and consumer advocates.

All mortgage companies (mortgage brokers, retail lenders, in-house mortgage operations, etc.) make money in pretty much the same way. Every day, they get wholesale rates in the back door, based on what investors (pension funds, endowments, hedge funds, etc.) are willing to pay for new mortgages. Out the front door come the retail rates borrowers actually pay.

The difference—call it a markup—covers their overhead (rent, salaries, advertising, etc.), plus the company's profit and the loan officer's commission.

The trick is that the "markup" comes in three forms: fees, points and a higher rate.

• Fees: Mortgage companies usually charge buyers a thousand dollars or more in fees, including "application fees", "underwriting fees", "processing fees", "admin fees" and "funding fees".
• Points: Sometimes called an "origination fee", points are calculated as a percentage of the loan amount. One point equals one percent of the loan. So on a $400,000 loan, a half-point origination fee (0.50) would be $2,000.
• Higher Rate: Investors are willing to pay mortgage companies extra for the same loan with a higher rate. For example, investors might pay nothing for a loan at 6%; but for the same loan at 6.375%, they might pay the mortgage company $4,000.

Mortgage companies are free to use whichever combination they want in order to attract customers, but still make money. Some market low rates (like those who advertise in online or newspaper rate charts), but make it up with fees and points. Others market low or no fees (Bank of America comes to mind), but charge higher rates. You'll pay in one way or another, because mortgage companies have to make money.

But it is in every mortgage company's interest to make a true apples-to-apples comparison difficult. Otherwise it would drive margins down to nothing. In the end, they are all selling the same product, and it is hard to keep it from becoming completely commoditized.