Origination Fee

An origination fee is a charge a lender imposes for underwriting, processing and making a loan. It is stated either as a percentage of the amount borrowed or as a flat dollar amount, and it compensates the lender for the work and risk of putting the loan on its books rather than for the use of its money over time.

What is useful to know about the phrase is that it is not defined where you would expect it to be. Regulation Z, the rule that governs consumer credit disclosure, defines no such fee: its definitions section and the definitions inside its high-cost, higher-priced and ability-to-repay provisions contain nothing called an origination fee. It captures the charge instead through a defined term that covers far more than this one item, the prepaid finance charge, which 12 CFR 1026.2(a)(23) defines as any finance charge paid separately before or at consummation or "withheld from the proceeds of the credit at any time". The federal mortgage disclosure forms use Origination Charges as a subheading for a block of itemized amounts "that the consumer will pay to each creditor and loan originator for originating and extending the credit" (12 CFR 1026.37(f)(1)), which is a heading rather than a definition. Federal student loans carry a statutory loan fee set by the Higher Education Act. And the tax code reaches the same charge under the heading points. Four regimes, four names, one line on a statement.

On non-mortgage closed-end credit, the fee is usually withheld from the advance, and that is what makes the annual percentage rate exceed the note rate. Because a prepaid finance charge reduces the amount financed without reducing what is repaid, the borrower receives less than the face amount of the note while owing all of it, and the disclosed rate has to reflect that. Published material on personal loans works that arithmetic in full, including a worked comparison of a lower rate with a fee against a higher rate without one. Published material on debt consolidation loans covers the version of the problem that arises when the advance is supposed to pay off a known set of balances and arrives short by the fee. The point to carry into any comparison is that a rate and a fee are not separable questions, and the annual percentage rate is the figure that has already combined them.

On a mortgage the fee is usually paid at closing rather than deducted, and it sits inside a labeled block. The Loan Estimate groups the lender's own charges under "Origination Charges", which is where an origination fee, an application fee, an underwriting fee and any discount points appear. What a lender may and may not change between the estimate and the closing is governed by tolerance rules, and published material on closing costs covers those. The distinction worth carrying is between a charge that pays the lender and one that pays a third party, because the two behave differently both at closing and, as below, at tax time.

Federal student loans have a fee that is neither negotiable nor set by the lender. It is a statutory loan fee, deducted proportionally from each disbursement, and its percentage is re-set for each federal fiscal year by sequestration under the Budget Control Act rather than by any inflation adjustment. The Department of Education announces the applicable percentages for loans first disbursed on or after each October 1 in an electronic announcement to financial aid administrators. Because the figure changes on that annual cadence and applies by first-disbursement date rather than by academic year, the percentage for a specific loan is worth reading off the disclosure for that loan rather than off a general reference. The practical consequence is the same as on a personal loan: the school is credited less than the amount borrowed, and the borrower repays the full amount.

The tax question is the one that cuts across all three, and it turns on what the charge bought. IRS Publication 936 states that points "may also be called loan origination fees, maximum loan charges, loan discount, or discount points", so a line item labeled as an origination fee on a home loan may be points, and points are interest, deductible under the rules for points. In the same publication the IRS draws the other half of the line: "Amounts charged by the lender for specific services connected to the loan aren't interest", giving appraisal fees, Department of Veterans Affairs funding fees, mortgage insurance premiums, notary fees, and preparation costs for the mortgage note or deed of trust as examples, and stating that those cannot be deducted as points either in the year paid or over the life of the mortgage. The same test appears in the student loan rules, where Treasury Regulation section 1.221-1(f) treats origination fees that represent charges for the use or forbearance of money as interest; published material on the student loan interest deduction covers what that is worth. So an origination fee is deductible interest, or a non-deductible cost of getting the loan, depending on whether it was a charge for the money or a charge for work. The deductibility tests for points themselves, including the conditions for deducting in the year paid rather than over the life of the loan, are their own subject.

Two things a borrower can do with all of this. First, treat the fee as part of the price rather than as a separate question, and compare offers on the annual percentage rate rather than on the rate, because that is the figure that has already absorbed the fee on closed-end credit. Second, on a mortgage, read the Origination Charges block itemized rather than as a total, because the split between the lender's own charge and charges for specific third-party services is what determines both what can change before closing and what is treated as interest afterwards.

The lender states the fee as a percentage of the amount borrowed or as a dollar figure. On consumer and student loans it is usually withheld from the money paid out, so the borrower receives the loan less the fee and repays the whole loan. On a mortgage it is usually itemized on the closing statement and paid then, out of the borrower's funds or, in some structures, credited by the lender in exchange for a higher rate. Either way it enters the finance charge and therefore the disclosed annual percentage rate.

A hypothetical example of the same fee behaving differently by product. Theo borrows $12,000 on a personal loan with a 5% origination fee. The fee is $600, it is withheld from the advance, and $11,400 reaches his account while he repays $12,000 plus interest. Now suppose the same $600 is charged on a mortgage instead. It is not deducted from anything; it appears in the Origination Charges block and is paid at closing, so the borrowed amount is unaffected and the cash required to close rises by $600.

A hypothetical example of the tax split. On that mortgage, the closing statement shows a $600 origination fee, a $650 appraisal fee and a $180 charge for preparing the note. Under Publication 936 the appraisal and the note preparation are charges for specific services and are not interest, so $830 of the $1,430 is simply a cost of borrowing. Whether the remaining $600 is deductible as points depends on whether it satisfies the tests for points, which is a separate question with its own conditions.

Pros

• It is disclosed as a dollar figure before you sign, unlike costs that only appear once interest starts running.
• Paying a fee for a lower rate can be the cheaper deal on a loan you expect to keep, and the annual percentage rate is designed to let you check that.
• On a mortgage, some of what is charged under this heading may be interest for tax purposes, which no interest rate line will tell you.

Cons

• Deducted from the advance, it means borrowing more than you receive and paying interest on the difference for the whole term.
• It is charged whether or not you keep the loan, so it is a pure loss on a loan repaid or refinanced early.
• The phrase is not defined by any consumer credit rule, so what is inside it varies by lender and has to be read from the itemization.
• On federal student loans it is not negotiable and not avoidable, and it applies to the amount borrowed rather than to the amount the school receives.