Can we talk about risk based pricing?
In the simplest of terms, risk based pricing is a system where the interest rate and/or fees paid for a mortgage vary based on the characteristics of both the borrower and the loan itself.
Some borrowers are more likely to default. Some loan types, such as those with lower down payments, cost the lender more when they go bad. It really is a straightforward system designed to equitably align the costs and rewards for banks and borrowers by assigning a rate that, as accurately as possible, reflects the risk of default.
It’s a nearly universal practice in mortgage lending, and whether you know it or not, the rate you are carrying right now probably included at least one adjustment to the rate or fees you were charged.
There are, quite literally, dozens of variables that can impact the price, or rate on a given mortgage, but the two most important are loan-to-value (equity in the home), and credit score.
Generally speaking, the higher the credit score, and the lower the loan-to-value, the better your rate.
We bring all this up because with defaults and losses on the rise (Freddie Mac lost $821 Million dollars last quarter) Fannie Mae is changing their risk based pricing fees, or "hits." At Fannie, these are known as LLPA’s or Loan Level Price Adjustments, and this is actually the third such adjustment since November of last year.
Take a look at this graphic (click to biggify), straight from a document called Updated Adverse Market Delivery Charge and Flow Business Pricing Requirements, which was released on Monday, right here. We can think of no better way to illustrate how down payment and credit score interplay to drive the rate you actually get.
We’ve marked this up to illustrate what has changed since the last adjustment by Fannie. Some are for the worse (in red.) Some were for the better (green). The negative negative numbers are credits, positive numbers are fees.
It’s important to understand that the items in the chart are not adjustments to the rate, but to the price of a loan at any given rate.
Adjustments can be paid (OR credited) in a lump sum, up front, as part of your closing costs, or as a slightly higher (or lower) rate.
Here’s a prime example of how the specific characteristics of the loan, AND the borrower can impact the cost of financing.
For example, if someone with a credit score of 685 puts 15% down on a purchase, there is a .5% price adjustment. This means you can pay .5% of your loan amount up front, or take a rate that is .125% higher. If that same person had a credit score of 675, the adjustment balloons to 1.5% of the loan amount, or .375% higher in rate.
On a $200,000 loan, that’s a difference of $2000 up front, or $38.00 per month over a 30 year term.
The moral of the story: Even as home prices fall, the cost of financing those homes will steadily rise, especially if you have imperfect credit and lack a big down payment.