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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 | Comments

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 | Comments

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 | Comments

Infectious Hyperbole in The Mortgage Industry

June 17th, 2008 Categories: Mortgage News, Real Estate News

Market bubbles and depressions tend to be more social phenomenon than rooted in fact.

Credit Crunch, Mortgage Meltdown, Sub-Prime Crisis, Alt-A Debacle, Housing Doom, Bursting Bubbles…the cliches are as creative as the financing options that used to permeate the marketplace. But what are the real numbers behind such doomsday hyperbole?

They’re not quite as sexy nor remarkable:

National Foreclosure Rates…

The Spin: National Foreclosure Rate Almost Doubles in 2008! | Foreclosures Hit Historic Highs | Homes in Foreclosure Top 1 Million

Reality: National Foreclosure Rate = 0.7%…up from 0.4% around this time last year. Roughly 7 out of 1000 homes are in foreclosure.

National REO Rates...REO or Real Estate Owned property is the ‘inventory’ banks hold, homes they likely foreclosed on and have yet to resell back into the marketplace.

The Spin: Bank REO’s up 100% From 2007

Reality: National REO Rate = 1.0%…up from 0.5% last year.

With all of the suspect to downright criminal practices that have been unveiled in the mortgage industry over the past year and a half, coupled with mainstream media spin, one would think that the housing and mortgage markets are in a state of pending armageddon, as in the end of days are upon us. It’s simply not true. Yes foreclosures are up and will likely continue to rise but they are the result of unprecedented, unsustainable expansion and growth…what goes up must come down at some point.

During times of lower trending mortgage rates, property generally appreciates as consumers can afford ‘more house’, sales flourish. Consumer defaults and subsequent incidences of foreclosure remain low because money is cheap. When rates rise the same consumer cannot afford the higher costs, appreciation levels or dips (depreciation), defaults and foreclosures increase. -Masters in Rocket Science not required to understand these fundamental market corollaries.-

Much of the skewed perception results from looking at the state of the union through the wrong set of glasses. Map mash-ups like this one:

…do well to point out which States have:

A. The highest degree of mortgage fraud/predatory lending.

B. Fundamentally impractical (stupid) appreciation.

C. Deteriorating local economic conditions.

D. All of the above.

A more useful set of information would compare common interest rates (and their indices) against home sales, values and the relative number of delinquencies/foreclosures across recent history.

Since I can’t find this chart, nor have the time to create one, I’ll use a few others’ ‘chart porn’.

annualehsapril082.jpg

According to this Calculated Risk chart, between 2002 and 2007 there were ~37,950,000 home sales.

What caused this historically explosive growth? Historically cheap and easy money.

The indices in the chart above represent those that are tied to popular mortgage programs. The COFI, MTA, and CMT directly effect (the terribly abused) Option ARM programs while the LIBOR is the index for many conforming ARM mortgages. It’s easy to see that home sales and prices blew up as rates bottomed out in late 2003, early 2004. Lower rates = lower payments. Lower payments = lower income needed to qualify for a mortgage. Lower qualification requirements = more qualified applicants…you get the point.

Consumer demographics that historically would have never qualified for a mortgage suddenly and briefly did qualify. Lenders threw gasoline on this spark and continued pouring it on by further dropping long standing underwriting qualification criteria. Wall Street greatly subsidized the raw fuel to further this incendiary trend: money, gobs of it. The Dream of Homeownership was sold like hard candy. For those consumers that f into the brief

The indices above reached their peak around July 2006, not coincidentally the wheels began to loosen on the market shortly after this and the sky began to fall shortly thereafter…

Advancing to February 2008, median home values and sales are actually increasing. What, Why, How? Rates have recently trended downward again, relieving some of the downward pressure in the housing market.

Studying the data above, it’s relatively surprising that the ‘housing epidemic’ hasn’t actually become one on par with how big the ‘housing bubble’ actually got. The mortgage and housing markets may be suffering from a bad cold, but it’s far from terminal. Much of the same infectious exuberance that permeated the housing market from 2002-2006 has today mutated into a plague of doomsday hyperbole. Market bubbles and depressions tend to be more social phenomenon than rooted in fact. A disjunctive phenomenon can drive an otherwise practical market into uncharted, volatile territory…alas hindsight is 20/20.

So, knowing what we now do, how can the highly contagious, overly optimistic peaks and financially draining valleys be mitigated in the housing and mortgage markets?

A logical first step is transparent access to better mortgage data, I know someone who has a line on this ;)  Next would be understanding how to best disseminate through and correlate it against housing market data using meaningful, effective strategies.

The relatively new real estate futures market could serve as an effective tool to hedge against impractical social phenomenon like bubbles. Futures markets are speculated by highly informed and educated people who have access to quality data that can spot potential bubbles well before they get too big. If they begin selling short, its a good idea to curb the enthusiasm. In the alternative, if they’re bullish or going long, lower interest rates, property appreciation, new housing starts and higher sales are likely.

It’s about time these Industrial Age marketplaces started using Information Age practices to stem future ‘epidemics’ and other like hyperbole from unnecessarily spreading…

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Authored by Jeff Corbett | Comments

Conforming Wholesale Mortgage Rates for 6/16/08

June 16th, 2008 Categories: Mortgage News, Real Estate Technology, Tranparent mortgage pricing, Yield Spread Premiums

Originally posted on www.ratespeed.com/blog…

All subsequent daily conforming wholesale interest rate pricing posts, other schwag, definitions, etc. may be found over there…

picture-2.png

What you see above is a screen shot from a results page generated by RateSpeed at 1:41pm on 6/15/08.

The risk based credit, financial and property criteria used to generate the above quote is as follows:

Purchase, Primary Residence, Single Family Residence, Fully Documented income, Debt to Income <39%, Loan To Value <80%, $400k Loan Amount, 700 FICO score.

Don’t believe what you see? Try it out yourself.

Shortly, RateSpeed will be enrolling 25 mortgage professionals as beta testers. Are you a mortgage professional looking to differentiate yourself in the market? Stay tuned to find out how you can be one of the early adopters in the transparent mortgage revolution.

Defining the fields and columns above:

Conf 30 Yr Fixed.

This is the term of the mortgage program. In this case the program is a traditional conforming 30 year fixed mortgage product.

Rate.

This is the interest rate of the loan.

APR. Annual Percentage Rate.

APR, in this alpha rendition, will only account for the Broker/Banker Fee. Traditionally it will (and should) include all closing costs. IMO APR is confusing and manipulatable.

Loan Amount.

Self explanatory, the dollar amount of the mortgage.

Monthly Payment.

How much you would pay the mortgage provider each month. Includes principle and interest.

Price.

This is the % cost or rebate that the given interest rate yields in the wholesale market. The Loan Amount is multiplied against the Price to equal the dollar ($) amount in cost or YSP credit.

YSP Credit.

RateSpeed is about choice and displays five levels of Price, one Price below Par (a Par rate is the lowest interest rate a borrower qualifies for, given by the wholesale lender) and four above Par. The higher Rate one chooses above Par the more YSP Credit (or cash rebate) the consumer may receive and apply toward closing costs (Broker/Banker Fee and 3rd Party fees, i.e. appraisal, title, escrow, home inspection etc). An interest rate below Par will cost a consumer to acquire, often times called ‘buying down’ an interest rate.

In the above 30 Yr Fixed, $400k Loan Amount example:

6.25% would yield $1084.00 in cash from the wholesale lender to the consumer to be applied toward closing costs.

6.625% would yield $5844.00 in cash from the wholesale lender to the consumer to be applied toward closing costs. The first $2000 would pay the Broker/Banker fee and the rest may be applied toward 3rd party closing costs (in this scenario).

Broker/Banker Fee.

This is the (negotiable) flat fee the mortgage professional is charging to close this loan. It is completely up to the mortgage professional what this fee ultimately is, RateSpeed does not mandate what a mortgage professional can charge.

$2000 is what we chose to represent as the Broker/Banker fee in this example and should not be interpreted as what all licensed mortgage professionals may charge who offer RateSpeed to their clients. The fee may be more or less, completely dependent on the mortgage professional, but always disclosed up-front.

Net Cost.

Net Cost = Broker/Banker Fee minus (plus) YSP Credit (cost).

Using the same qualifying information, compare and contrast the rates and pricing you see above to other mortgage websites and similar applications and you will quickly see the difference between a transparent mortgage professional who offers RateSpeed and those who don’t…unabated access to real time, best-case wholesale mortgage rates and pricing.RateSpeed: Enabling mortgage consumers and professionals to make smarter decisions with better information.

-

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Authored by Jeff Corbett | Comments

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