Risk Based Pricing How Mortgage Rates are Determined. Credit Scores and History
July 10th, 2008 Categories: Mortgage Advice, credit scoring, risk based pricing
Risk Based Pricing How Mortgage Rates are Determined. Credit Scores and History
The following material isn’t all that easy to follow, there are many moving parts. It’s the equivalent of college level mortgage economics, I’ll try to be a succinct as possible.
First, IT IS VITAL that you understand exactly what your credit scores are and why, as they are the single most influential driver behind the risk based pricing of mortgage rates. Further, many people are unaware that they can improve their scores enough to yield better risk pricing and lower rates in a relatively short amount of time by employing sound strategies with the help of qualified mortgage professionals and some 3rd party services. A one (1) point difference in credit score can have large financial repercussions when qualifying for a mortgage. Accessing, understanding and pro-actively addressing whats on your credit bureau before you apply for a mortgage is absolutely imperative.
Credit scoring is a complex algorithm that considers many different factors, all weighted differently. Since these factors typically change every month the overall score does too. Some factors include:
- Number of total (open and closed) accounts…aka ‘trade lines’
- Type of account
Revolving (typically credit cards), Installment (automobile loans, student loans, and/or bank loans) and Mortgage. - High-credit limits vs. current balances
Example: Credit card has a $10,000 limit and a $3000 balance owed. - Length of time accounts are open
- Payment history
Utility bills, cell phone etc don’t count towards credit scores unless you don’t pay them (ever), then they may appear as a judgment on your bureau, which will lower a credit score substantially.
The mortgage industry uses a very succinct and comprehensive credit bureau which is far different than the ‘get your free credit bureau’ and other like offers. Most consumers don’t know that there are different credit report types. MyFICO provides a ‘mortgage quality’ Tri-Merge (an aggregate of all three, Experian, Equifax and Trans-Union) credit reports as well as ancillary services that can assist you in improving and maintaining your credit files. Mortgage professionals have access to similar tools and service.
Despite common perception, credit scores alone are not the single driving factor for proper mortgage qualification, the depth of a score is just as important. Credit depth means having accounts open for extended periods of time (2+ years), ‘high balance limits’ on accounts that exceed ~$5000, automobile or other installment loans as well as previous and current mortgage loans…
For the purpose of this post, we’ll assume that the scores and scenarios used below have enough depth behind them to qualify for a mortgage.
Below is chart pulled from a conforming lenders rate sheet demonstrating Risk Based Pricing (RBP) adjustments for credit scores with their Loan to Value (LTV) corollaries:
-Credit Score and LTV Risk Pased Pricing Chart
First thing you should note is the relative increases in price when comparing credit score to LTV. As LTV’s rise, price (and rate) become more expensive. Lower credit scores in relation to LTV cause further RBP’s for the worse. (Click the image to enlarge)
Notice that credit scores above 720 cause no RBP adjustment for the worse, this shows unequivocally how important good credit is for obtaining the best price (and rate) possible. Few other notes:
- LTV’s <60% have either no adjustment to price (or price for the better if the credit score is above 700), reason being that high equity properties are considered far less risky due to the blunt point that if the bank had to foreclose on the property they would likely get their money back and then some.
- LTV’s from 60.01% to 70% begin to trigger RBP adjustments for the worse, to the tune of 0.500(%) - 0.750(%) (higher cost and rate) depending on credit score.
- LTV’s >70.01% further a RBP adjustment for the worse, ranging from 0% to 2.75% depending on credit score.
- 1 point, the difference between a 679 and a 680, can effect the price of an interest rate up to .750%
This a real life example of the ‘Credit Crunch’; RBP adjustments for LTV’s and correlating credit scores are far more ‘expensive’ than they used to be. Today a borrower needs higher credit scores and lower LTV’s to acquire favorable rates and prices compared to what was available less than a year ago.
How do RBP adjustments actually effect interest rates?
<–What you see here is a daily pricing chart for a Conforming 30 Yr Fixed program.
Any price below 100.00 costs money to obtain, any price above 100.00 pays money (YSP) to obtain.
If there are no RBP adjustments, a 6.125% rate (25 day lock period) is the best available that doesn’t cost money to obtain, it actually pays 100.139 or 0.139% of the loan amount (YSP). If the loan amount is $300,000 then a 6.125% rate would pay $417.00 in YSP to the borrower ($300,000 x .139% = $417.00).
At 6.500% with no RBP adjustments and a $300,000 loan amount, the YSP rebate to the borrower would be $5004.00 ($300,000 x 1.668% = $5004.00)
25 days and 60 days are the ‘lock periods’. Once you lock a loan you have either 25 or 60 days to close it (with this lender), depending on which price you choose. When a loan is locked the bank ‘holds’ that money to fund the loan (which costs them money along the lines of the Federal Reserve Overnight Rate), the shorter the lock period the better the price.
To demonstrate how credit score RBP can effect a rate and cost, lets compare a borrower who has a 660 credit score and needs 90% LTV financing to a borrower that has a 720 score (same 90% LTV) under the ‘25 days’ lock period.
Looking at the credit score and LTV chart above, a 660 score at 90% LTV yields a RBP for the worse in the amount of 1.250(%).
Now look at the 30 Yr Fixed chart: If a 660 credit score borrower wanted the 6.125% rate you must subtract 1.250 from the price next to the rate, or 100.139 - 1.250 = 98.889. The difference between 100.00 and 98.889 is 1.111(%). If the loan amount is $300,000 and the cost is 1.111(%), it would cost $3333.00 ($300,000 x 1.11%) to obtain the 6.125% rate for the 660 borrower at 90% LTV.
In the alternative, a 720 score at 90% LTV has no RBP adjustment and therefore could acquire the 6.125% rate for the 0.139% price, rebating $417.00 in YSP to the borrower.
So, to acquire the 6.125% rate, a 660 credit score borrower needing a 90% LTV mortgage will have to pay $3750.00 more than a borrower with a 720 credit score. Assuming all other RBP factors are equal.
Lets say the 660 credit score borrower wanted a rate that didn’t cost money to acquire. To do so you must find the price and corresponding rate that meets or exceeds 101.250 to account for the 1.250(%) RBP adjustment. In this example, 6.500% has a price of 101.668. Adjusting for the RBP of 1.250 yields a net price of 100.418 (101.668 - 1.250 = 100.418) or 0.418%. At a $300,000 loan amount, a 6.500% rate after the RBP adjustment would rebate $1254.00 ($300,000 x .418% = $1254.00) to the borrower in YSP.
All this may seem pretty complex until you begin to figure in other RBP factors like Loan Type and Property Use, not to mention the ambiguous rules of credit depth property location…then the fun (and mistakes) really start to fly. It’s no wonder many consumers are either honestly misquoted, bait and switched (or worse) with great frequency. There are almost more moving parts than can be counted. Fortunately there are competent mortgage professionals (and slick technologies) that can quickly disseminate through all this information, calculating mortgage rates and their respective prices accurately and transparently for the borrower.
If I lost anyone here feel free to hit my email or comment thread…chances are if one person has a question many more have the same question. If you made it all the way through this post and have a greater understanding for how mortgage rates are determined, give yourself a well deserved pat on the back…it’s not easy material to follow.
Next up: Loan Amounts and Loan to Value.
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