Risk Based Pricing How Mortgage Rates are Determined Loan Amount and Loan to Value

Continuing on down the road of how mortgage rates and their underlying price are determined considering common Risk Based Pricing (RBP) factors, our next stop is the Loan Amount and the directly related Loan to Value (LTV).

Loan Amounts, or the actual dollar amount being financed, have become more of a focal point when determining what program and rates a borrower qualifies for…and a moving target.

Recent changes in underwriting guidelines issued by Fannie Mae & Freddie Mac (Conforming) and FHA mortgages have increased minimum Loan Amount limits, in part to absorb the business left behind by the closing (or substantial downsizing) of major portfolio lenders. Fannie, Freddie & FHA Loan Amount limits are now determined by individual Metropolitan Statistical Areas (MSA’s) median home values, with accepted limits up to 125% of said median value at a cap of $729,750.

If 125% of the average median home value for a given MSA is less than Loan Amount limits in place, the current limits shall remain in place.

For example:

The Los Angeles California MSA median home price is ~$588,000. $125% of $588,000 = $735,000…So the FHA and Freddie Mac Loan Amount limit cap of $729,750 takes effect, which is still well above prior conforming Loan Amount limits of $417,000 and FHA Loan Amount limits of $271,050.
The Buffalo-Niagara Falls MSA has a median home price is $104,000. 125% of 104,000 = $130,000…So existing Conforming ($417k) and FHA ($217k) Loan Amount limits remain in effect for this area.

The method behind the madness resides in the fact property values are substantially different depending on where that property is located. $400,000 will buy you a really nice house in Erie County New York, while you’d be lucky to find a starter home for that price in L.A…so Loan Amount limits are set to accomodate these hyper-local conditions.

Under older guidelines people who today live in these ‘high value’ areas would’ve been precluded from getting a better interest rate or qualifying at all, due to the mass attrition of lenders in the mortgage market

In any case, if a borrower needs a mortgage with a Loan Amount that is above the Conforming or FHA limit for their specific MSA, there is a RBP for the worse.

On the contrary, there are also typically RBP’s for the worse for Loan Amounts below certain values. For example, Loan Amounts from $0 – $99,999 will RBP for the worse. Typically the lower the Loan Amount the worse the negative adjustment.

Loan to Value, or LTV, is the ratio by the loan amount divided by to the value of the property (or purchase price, whichever is less), i.e.:

Loan Amount(= $400,000) Property Value(= $500,00)…$400,000/$500,000 = 80% Loan to Value (LTV)

LTV measures leverage. According to definition the more you leverage an asset the riskier the transaction becomes, thus higher LTV %’s yield RBP adjustments for the worse. How much worse typically also depends on credit score. This was demonstrated in detail in my last post.

Click image to enlarge…

Tangible evidence of ‘the credit crunch’ may be found in the table above. Negative pricing adjustments typically didn’t find their way into LTV’s below 80%, now they begin at = >60% LTV’s. This change is likely due to lenders predicting a relative degree of depreciation throughout much of the country, although IMHO the 20% shift seems to be too aggressive. 20% declines in value aren’t likely anywhere, with the exception of areas that experienced ridiculous growth and/or appreciation, such as coastal California, Las Vegas, and southeastern Florida and a few other hyper-local markets where the economy is particularly bad.

Looking closer, the real pinch where LTV pricing adjustments for the worse occur when credit scores fall below 680, causing a RBP for the worse to the tune of .750%, which can cause an interest rate to rise as much as a full 1%.

There is no way to escape a RBP for the worse related to LTV unless one has a middle credit score equal to or above a 720.

While the days of free and/or easy money should have come to an end a long time ago, it seems that lenders may be overcorrected a bit. Eliminating mortgage programs that allowed 100% financing with stated income or 580 credit scores, ’stated wage earner’ documentation types and other logically flawed underwriting guidelines was an easy call, but choking out what had been sound lending practices for decades may be doing more harm than good.

Sound borrowers are having trouble finding financing as banks have reversed their qualification methods from ‘find a way to do the deal’ to ‘find a reason to turn it down.

At the end of the day the result is that unless you have a substantial down payment (or equity), a very good credit score and a Loan Amount limit within established guidelines, mortgage rates are getting to be rather expensive. The rates often advertised on TV and a plethora of online websites commonly reflect ‘best case’ qualification data, considering credit scores above 720, Loan Amounts within GSE guidelines and LTV’s at or below 80% (amongst other factors). If your real estate financing qualification criteria fall below (or above) any one of these threasholds, the interest rates you see advertised aren’t the interest rates you’re likely to qualify for.