Risk Based Pricing. How Mortgage Rates are Determined
July 2nd, 2008 Categories: Mortgage Advice
Risk-Based Pricing (RBP) and Mortgage Rates.
Risk Based Pricing is quite simply, a pretty complex topic…so over a series of posts (I was going to throw up one long post but could hear heads hitting keyboards after trying to read the first 5 pages) I’m going to break down how each of these general factors and subsets effect program, interest rate and pricing for potential borrowers.
The opening cited** content below is paraphrased from Wikipedia. The driving reason for using this source is that I personally submitted much of the relative content to the online encyclopedia over a period of time.
Risk-based pricing is a methodology adopted by most lenders in the mortgage industry to mitigate the perceived risk of lending money to a given set of financial, credit and property factors.
Lenders effectively ‘price’ loans according to these individual factors and their multiple derivatives. Each derivative either positively or negatively affects the price/cost of an interest rate. For example, lower credit scores will yield higher interest rates (higher price) and vice-versa, a non-owner occupied (or investment) property will yield a higher price than a primary residence; providing less verifiable income documentation (due to self-employment or otherwise) will qualify for worse pricing (higher interest rate) than someone who fully documents all income appropriately.
RBP gets even more complex when you consider that one factor may depend on another factor to determine how price may or may not be adjusted. For example, ’stated’ or reduced income documentation will typically cause a pricing for the worse (higher rate), but if the credit score is high enough some lenders will offset the pricing hit with a correlating improvement in price.
A criticism amongst consumers and other groups has been that RBP can make ’shopping’ for the best interest rates very difficult and opens the door to potentially deceptive practices due to the relatively low education material available to exactly how RBP works. Further, program guidelines change often and the base price/cost of interest rates change daily (up to three times in some cases), so what may be available today may not be available tomorrow. It is almost impossible to tell at first glance if one is qualified to get an advertised rate or exactly what interest rate they qualify for at all. Risk-based pricing can be manipulated to wield deceptive marketing practices, such as the bait and switch.
Consumer-rights advocates also believe that risk-based pricing in the extreme hurts financially disadvantaged and vulnerable consumers by cutting them off from reasonably affordable capital and exposing them unwittingly to soaring interest rates and unsustainable financing schemes that erode equity and may lead to default. The fairness of these lending practices, more specifically the proper disclosure of such within the mortgage industry is being investigated by Congress.**
The primary risk based factors (and their subsets) considered by lenders that dictate what mortgage programs and interest rates a given borrower qualifies for include:
- Loan Type
- Property Type
- Property Use
- Property Location
- Credit Score and History
- Debt to Income Ratio (Gross Income vs Monthly debt obligations disclosed by the three main credit bureaus.)
- Loan Amount
- Appraised Value/Purchase Price
- Loan to Value/Purchase Price
- Documentation Type
In this post, I’ll cover common Loan Type/Purpose and Property Type factors.
Loan Type/Purpose
Subsets:
- Purchase
- Rate/Term Refinance
- Cash-Out Refinance
Purchase loans are deemed to contain the least amount of risk and thus ‘price’ purchase loans most favorably, yielding lower interest rates.
Rate/term refinances are priced similar, usually identical to purchase loans, with no price increase. The purpose of a rate/term refinance, as the name implies, is to reduce the interest rate, payment, and/or overall term of the mortgage. To qualify as a rate/term refinance the cash received by the borrower at closing may typically not exceed $2000.
Cash-out refinances are deemed to have a higher risk factor than either rate/term refinances or purchases due to the resulting increase in loan amount relative to the value of the property, thus risk-based pricing typically mandates a pricing increase (higher interest rate) for this loan purpose.
Property Type
Subsets
- Single Family Residence
- Condo/Townhome
- 2-Unit (Duplex)
- 3-4 Unit
- Modular
Single Family Residence (SFR) is considered the lowest risk of property types, so no increase in risk pricing (and rate) is implemented.
Condo/Townhomes are often risk priced the same as a SFR especially if the Property Use is a Primary residence. Price exceptions for the worse are common if the property is above 4 floors tall, reasons include disparity in construction quality, as many ‘hi-rise’ properties were converted from hotels or other mixed-use purposes. This is a very lender specific risk-price adjustment and can vary widely.
2-Unit properties or a Duplex will typically risk price for the worse, resulting in a higher interest rate.
3-4 Unit properties typically risk-price slightly worse than a 2-Unit duplex.
Modular built properties have evolved substantially in overall quality over the past 5 years to the point they rival and can even exceed the quality of a stick built SFR. For this reason most modular homes have no risk price increase. Modular homes are pre-manufactured off site, usually in a large warehouse and delivered in pieces to the home-site where construction is completed. Recently built modular homes are almost impossible to identify vs traditional ‘stick-built’ construction.
The term ‘manufactured home’ is often mistakenly interchanged with ‘modular’ homes. Manufactured homes typically encompass the definition of a mobile home, which are risk-priced substantially worse than any other property type and/or do not qualify for conventional financing. Talk with a licensed mortgage professional to determine how a specific ‘pre-manufactured’ or other property type is risk-priced.
Next I’ll cover Property Use and Property Location…
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