(This is Part 1 of a three-part series. See Part 2 and Part 3.)
Q: What are referral fees?
A: Referral fees are payments made by service providers to other parties as quid pro quo for referring customers. For example, a real estate agent is rewarded for sending a borrower to a loan provider. The reward, whatever form it takes, is a referral fee.
Referral fees should be distinguished from referral power, which is the ability to direct a client to a specific vendor. Referral power is based on information and authority of the referrer, and ignorance of the client. The real estate broker has information about the reliability of loan providers, and may have authority in the eyes of the borrower. The borrower may be ignorant about loan providers
Not everyone with referral power collects a referral fee. For example, I have sent many mortgage borrowers to Upfront Mortgage Brokers but I have never collected referral fees from them.
Q: Why are referral fees considered bad?
A: One reason is the widespread prejudice that charging for something that takes no effort, or almost none, is like being paid for nothing. We undervalue information.
If the refrigerator repair person comes to our house and has to tinker around to fix it, we pay his $50 fee without a murmur. If he tells us over the telephone to flip the XC switch and give it a kick, assuming this works, we are affronted at being billed $50, even though the value received by us – a refrigerator that now works — is exactly the same.
A second reason for the hostility to referral fees is the fear that payment for referrals will degrade the quality of the service. If a real estate agent collects referral fees from specialists, does he send borrowers to the best loan providers, or to the ones willing to pay the referral fee? This is a legitimate concern.
The third reason is a concern that referral fees raise the cost to the client. It seems plausible that if service providers have to pay referral fees, they are going to charge more in order to cover that cost.
This is the major concern with regard to referral fees in the home mortgage market. It overlooks that a service provider who is barred from paying referral fees has to find another way to market to those with referral power, and the alternative could well be more costly.
Q: Why are referral fees pervasive in the home mortgage market?
A: Because referral power pervades this market. Real estate and mortgage transactions involve a large number of diverse players who sell services that consumers are required to purchase. Since they are in the market very seldom, consumers typically don’t know who all the players are, or even what they do. They are thus heavily dependent on referrals from those who have this knowledge. Referral power in this market is based largely on the ignorance of consumers.
Realtors and builders have referral power on home purchase transactions, referring consumers to lenders and title agencies. Lenders and mortgage brokers usually select the appraiser and credit reporting agency on purchases, and all third party service providers on a refinance. Mortgage insurers are always selected by the lender.
Q: Do referral fees raise settlement service prices to consumers?
A: No, referral power raises prices to consumers, not referral fees. When there is referral power, service providers compete not for the favor of consumers but for the favor of the referral agents. Such competition raises the costs of service providers, which are passed on to the consumer.
Referral fees are a consequence of referral power. If we had a magic wand that immediately eliminated all referral fees but left referral power intact, it is as likely that prices to the consumer would rise as it is that they would fall. To service providers, referral fees are a marketing expense. Remove them and service providers would have to find other ways to market themselves to the same referrers.
Consider: A consumer (C) is required to purchase a service and looks to referrer (R), who directs him to service provider (S). S prices the service well above the lowest price he would be willing to accept because he must market to R and R is not sensitive to a price he doesn’t have to pay. Indeed, the high price allows S to pay R a referral fee. If the referral fee cannot be paid, S has to find another way to induce R to refer him to C, and that could cost S more than the referral fee. Elimination of referral fees, therefore, would not cause S to reduce his price.
Q: Why are referral fees illegal under RESPA?
A: Congress was offended by high mortgage settlement costs and the prevalence of referral fees, which they saw as related. The rationale of the restrictions imposed by the Real Estate Settlements Procedures Act (RESPA) is that “kickbacks or referral fees… tend to increase unnecessarily the costs of certain settlement services . . . .” (RESPA, Section 2601 (a)).
But Congress was wrong about that. Settlement costs are raised by referral power, not by referral fees, and RESPA fails to address referral power. Not surprisingly, therefore, the RESPA prohibition of referral fees has not reduced settlement costs at all, a fact acknowledged by HUD which has the unpleasant task of enforcing RESPA.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
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