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

August 4th, 2008 Categories: Mortgage Advice, risk based pricing

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 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.

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Authored by Jeff Corbett |

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:

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:

picture-3.png
-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:

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?picture-4.png

<–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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Authored by Jeff Corbett |

Risk Based Pricing. How Mortgage Rates are Determined Property Type and Property Use

July 7th, 2008 Categories: Mortgage Advice, risk based pricing

Risk Based Pricing.  How Mortgage Rates are Determined  Property Location and Property Use

In the world of residential mortgage Risk Based Pricing (RBP), Property Location and Property Use are two factors that have nothing to do with the actual borrower, whereas the same borrower would receive two different sets of program and interest rate quotes depending on where the subject property is located and what the property is used for.

Property Location has become much more prominent in RBP scenarios with the recent uptick in popularity of FHA mortgages.  Loan limits for FHA loans have become very localized, right down to the County level.  It’s possible that one County may have a loan limit of ~$417k with an adjacent County at ~$700k+, via FHA.  Loan amounts above local limits will cause a pricing for the worse, so location in relation to loan amount can be a substantial factor as to what interest rate any given borrower qualifies for.

Even without considering FHA loan limit guidelines, there are state level and regional rate and pricing guidelines…you wont get the same programs, rates and pricing in Kanosh, UT and Manhattan.  Property in locations deemed high risk (depreciating, bubble/volatile prone, high foreclosure, poor economy) are likely to see a pricing for the worse (higher interest rate) compared to ‘more stable’ locations.   There are even locations like the inner city of Cleveland, Ohio where many banks won’t lend, period, due to the depth of mortgage fraud that ripped through the city during the refi-boom.

Property based RBP changes can range from 0% to 2% (or pts) which may have a corollary  effect of increasing the interest rate 1+%.

Property Use is broken down into three subsets:

A Primary Residence is a property you plan to personally live in.  The bank thinks you’re likely to highly value and treat the house you live in with love and respect so properties that are used for primary residences have no RBP adjustment for the worse.

RBP adjustments for Second Homes are getting pretty lender specific, depending on secondary factors like credit score and Loan to Value (LTV).  Second Homes with LTV’s <80% generally have no RBP adjustment while an LTV >80% will require higher credit scores and RBP for the worse.    In order for a property to qualify as a Second Home, you can’t (claim to) make money by renting it out (this would make it an investment property), and you must represent that you stay at the property a certain amount of time each year.

Non-Owner Occupied or Investment Property will have a substantial RBP adjustment for the worse, typically between 1.5%-2.5% which may correlate to 1%+ increase in interest rate, compared to a primary residence or second home, regardless of  any secondary factors.  Secondary factors like loan amount and LTV play a heavy role in how big the adjustment is.

Where there is up to 2.5% (or points) on the table there are likely to be people trying to game the system.  Misrepresenting property use is a very common type of mortgage fraud since it’s heavily based on the honor system.  Yes, stating that a property you are buying will be your primary residence when you really intend to rent it out is mortgage fraud.  There are certain measures the bank and broker (should) go through to make sure the stated property use is in fact true.

Next up is Credit Scores and History…

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Authored by Jeff Corbett |

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:

In this post, I’ll cover common Loan Type/Purpose and Property Type factors.

Loan Type/Purpose

Subsets:

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 (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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Authored by Jeff Corbett |

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