Mortgages: What is Risk-Based Pricing?

What is risk-based pricing?

If you're researching mortgages in preparation for buying a home, you'll likely run across references to "risk-based pricing" or "loan-level pricing adjustments", descriptors that are sometimes used interchangeably. But what exactly do these phrases mean?

At its core, a risk-based price is a lender or investor's attempt to try to assign a value (cost) to a range of items that may make it less likely that you'll repay a loan... or potentially even default on your mortgage obligation altogether. These risk adjustments increase the return to the lender or investor to compensate for those risks.

In a perfect world, a potential borrower would pose no risk, and a lender would be happy to make funds available at a rock bottom rate. Essentially, a guarantee that borrowed funds have a 100% chance of being repaid (and with a bit of interest) is exactly what investors who buy U.S. government debt are looking for. While such a safe and sound investment carries little or no risk, it also provides little reward.

Conversely, borrowers that don't have the backing of the U.S. taxpayer aren't guaranteed to pay back loans in a timely manner (or at all), and so present a risk to the lender. Where the best possible borrower (like the government) will pay the lowest possible rate of interest, borrowers that aren't 100% guaranteed to repay are riskier, and riskier borrowers pay higher rates of interest.

With risk-based pricing, one overarching thing to remember: Higher risks mean higher rates and fees. As a borrower, you'll want to present as few of them as you possibly can in order to get the lowest borrowing costs.

What are "risks" in "risk-based" pricing?

Mortgage borrowers present risks in a few primary ways:

• Credit strength
• "Skin in the game", aka downpayment or equity
• Debt-to-Income (DTI) ratio

One of the primary items in risk-based pricing for mortgages is you, or rather, how well you have paid off other money you've borrowed. These actions are captured in your credit report and this information is turned into credit scores by private companies like Fair, Issac (FICO) and VantageScore, as well as other firms. These scores run on a scale from 300 to 850; a lower score indicates you have little credit and/or have badly managed the credit you have previously been granted.

The lower you are on the scale, the larger of a risk you present to the lender. Most lenders wont write you a mortgage if your score is below 620, although you may be able to get an FHA-backed "government" loan with score of just 580 (and possibly less if you can come up with at least a 10% down payment).

Related: Learn how to improve your credit score

So your credit strength can be considered a primary risk. The next risk in line is how much of your own funds you can commit to purchasing the home you want to buy -- your down payment (or equity stake in the case of a refinance).

Making just a small down payment means you have little "skin in the game", and having no real monetary connection to your property presents a risk. A small stake not only means that the lender must fund more of the purchase price, but can also represent an increased risk you might not manage the property well (since your loss would be slight), and might even walk away from it if you faced an expensive repair. This risk is greater if the borrower should encounter financial trouble that prevent them from making payments, or, as we learned in the last housing crash, if home prices should decline, leaving you "underwater." Even in the best of economies, there are at least some borrowers whose mortgage balances exceed the current market value of their home.

Some of this "skin in the game" risk is offset by outside insurance, called Private Mortgage Insurance (PMI) or, in the case of the FHA, a self-funding insurance pool called the MMIF. These insurance policies help cover some (but likely not all) of the cost of a lender foreclosing on a property, cleaning it up and reselling it. PMI policies also use risk-based pricing to come up with the costs you'll pay to protect the lender's interests, but FHA's MIP percentage-based charges are the same for all borrowers regardless of risk.

Then, there's the borrower's overall debt to consider, your Debt-to-Income (DTI) ratio. Even if you're a good credit risk and make a considerable investment in your property, carrying too much debt on a given income creates a risk, too. When an income is highly leveraged -- that is, when a borrower is carrying a lot of debt -- even a small wobble in that income stream can force some hard choices of what bills get paid and what do not.

It used to be a tenet of this kind of risk that in times of trouble, folks would always pay their mortgage first, and so preserve their place to live above other things, such as car payments and credit card debt. We learned in the Great Recession that this turned out not to be the case, as homeowners turned delinquent or even defaulted on mortgages while car and revolving credit accounts were being paid on time. Folks prioritized mobility and budget flexibility over guaranteeing themselves shelter. However, this may have been related to the crisis itself, which saw lenders overwhelmed and timelines for eviction and foreclosure stretching out to years in some cases.

Regardless, many highly-leveraged borrowers failed in that housing downturn, so standards for borrower debt loads grew in importance. While some lenders will allow you to carry DTI ratios as high as perhaps 50%, the Qualified Mortgage (QM) standard is for a maximum 43% DTI ratio.

While these three risks are the primary basic borrower risks used in loan pricing, there of course are others, such as erratic income streams and more.

Intersections of Risk

With the above as a backdrop, it's a little easier to understand that potential borrower A will have a different risk profile compared to potential borrower B, and that A and B will get different mortgage rates and fees than the other.

It's also not that difficult to grasp that the exact intersections of these risks will determine how large a difference in costs that there is. In fact, there is a risk grid used for mortgages -- a loan-level pricing matrix -- that is used to determine how much each risk adds to the cost of the mortgage. Here's an abbreviated example:

On such a table, the intersection of the borrower's credit score and down payment determine the primary difference in price; and additional fees would be added if the borrower's DTI ratio is above a given threshold, such as the 40% noted above (or 43%, or 50%, etc.).

Some borrower weaknesses (risks) can be offset with other strengths, at least to a degree. For example, a borrower with a very high credit score but a high debt load may not be perceived as riskier if he or she has a sizable down payment, deep reserves or solid asset strength on which to draw. In fact, there's also a matrix that lenders can use for such offsets; for example, a borrower with a 5% down payment and a DTI of 36% or below can be allowed to have a credit score would need a credit score of FICO 660 or more -- and they would need to hold cash reserves equivalent to as many as six months worth of housing payments. The risk of the lower down payment is partially offset by a higher required credit score and greater reserves.

Property Types, Loan Purposes and Other Risks

There are also risks not associated with the borrower's financial strength that also must be accounted for in the price of a mortgage, including:

• Loan type
• Property type
• Loan purpose / Occupancy status
• Size of the loan

With stable monthly principal and interest payments, fixed-rate mortgages pose the least risk, and that's especially the case with a shorter-term loan. Conversely, and while there are considerably fewer to choose from today, Adjustable-Rate Mortgages (ARMs) can pose certain risks, especially in cases where the borrower's credit is weak or only a small downpayment is being made. A rising payment over a period of time may make if difficult for a borrower to keep up, increasing the likelihood of delinquency or default.

The kind of property being financed can change the risk profile of the loan, too. Single-family detached properties have different risks than do attached properties such as multi-family dwellings or townhomes, while apartment buildings built as condominiums have different risks than either of those. With a single-family detached home, you typically own both the dwelling and the land on which it sits; that's not the case with other kinds of property, where the land or building may be a shared responsibility -- and the value of the home or unit can be impacted by forces beyond the borrower's direct control.

The intended use of the funds being borrowed can also be a source of risk. Are you looking for a loan to buy a home to live in? Is this a part-time residence, like a vacation or second home? Is it a property you are buying as an investment and intend to rent to others? Are you looking to do a cash-out refinance and pull some equity out of the property?

Different loan purposes change the risk profile of the loan being made. Owner-occupied single-family homes are the least risky of the bunch, but a second or vacation home is a luxury item that may not get the proper attention or see the loan be paid if the borrowers should find themselves in difficult financial straits. Loans made for investment properties usually depend on cash flow from renters in order to be paid each month, and there's no way to know if the owner of the property will have good or bad tenants who pay on time. As well, the lender cannot know in advance if the property owner will perform proper upkeep and maintenance on the dwelling to help preserve the property's value.

The size of the loan can also add a degree of risk. That's not because a borrower who has the credentials to cover an $800,000 mortgage is especially risky, but rather because the large dollar amount concentrates the potential for a large loss into one single loan. If for example a lender could make eight $100,000 loans, even if half of them failed for some reason this would still only be a potential $400,000 exposure to loss. Conversely, should a single $800,000 loan go south from a single individual borrower's deteriorated circumstance, all $800,000 that was lent becomes a potential loss.

As well, since "jumbo" mortgages are highly concentrated in certain markets, there's a bit of geographic risk to consider, too. Smaller loans spread across a wide range of borrower characteristics and geographic locations can help lower the risk of a single event or localized recession causing significant loss to the lender. On the other hand, a string of high-dollar mortgages all concentrated in a single area -- like a group of beachfront properties, for example -- could be all turned into losses in a catastrophic event like a hurricane. The size of the loan may not create a greater incidence of loss, but it can magnify the severity of that loss should it occur. As such, it's a risk for which the lender must also account.

There can be other kinds of non-borrower risks, too, and it's not unheard of to see things like regional or even state-specific loan-level price adjustments being made by lenders. After all, the risks and costs of doing business in one state is unlikely to be the same as in another.

How Do Risks Affect Your Mortgage Cost?

The presence of risks will increase your mortgage costs. How they increase your costs -- either via higher out-of-pocket fees or a higher interest rate -- is mostly up to you.

In most cases, the price increases due to the presence of a given risk or a combination of risks are expressed as fees. That is to say that Borrower A who presents no risk may be offered a loan at an interest rate of N% with no additional fees, while Borrower B can be offered the same N% interest rate but only if he or she also pays N$ in additional out-of-pocket fees. Both borrowers get the same interest rate, but Borrower B must come up with an additional pile of cash to obtain it.

That said, many or most add-on fees can be (and often are) traded for a higher contract interest rate. Considering that each 1% in risk-based fees can add a quarter of a percentage point to the base N% interest rate, a range of risks can push up the interest rate on the mortgage by a full percentage point or more very quickly.

If the buyer pays these risk-based fees in cash, the loan's interest isn't increased and the monthly payment is the same as Borrower A who presented no risks. However, if Borrower B elects to exchange paying these fees for a higher interest rate, raises the loan's monthly payment, which in turn limits the amount of mortgage that can be borrowed... and of course, the smaller loan amount helps temper the lender's risk, at least to a degree.

Of course, that's in cases where the borrower is using all their available income to qualify for the loan amount they need. There can be cases where the borrower is getting a loan amount well below their income's carrying capability their loan amount wouldn't need to be reduced, and they would simply pay the higher monthly payment.

All this said, it doesn't have to be all or nothing, though. A borrower could pay some fees out of pocket and accept a slightly higher rate, too. It's all a matter of how these costs fit into the borrower's budget, how high an interest rate their income can support and how much cash they wish to devote to the transaction.

Least and Most Risk: Hypotheticals

While there's not an infinite number of potential intersections that make up the price of a mortgage loan relative to its risks, there are still quite a few -- the basic credit score by loan-to-value ratio table has nine credit score "buckets" and nine loan-to-value ratio "buckets", so there's 81 potential combinations just to start with to produce the initial fee add-ons for the loan, and more may be added as things go along.

In a theoretical "best" borrower example, a borrower with a credit score at or above FICO 780, who is making a downpayment of at least 25%, has a DTI ratio below 40% and needs a non-jumbo loan amount to purchase a single-family detached home to live in would pay the base interest rate of N%, the lowest rate available with no add-on risk-based fees in the market at a given time.

The same borrower with a FICO score below 639, making a downpayment of just 5% with a DTI ratio of above 40% buying the same single-family owner-occupied home would pay the base rate of N%, but would need to pay about 2.625% of the loan amount in cash as fees to obtain it. Traded off into the interest rate, this borrower would see an interest rate of N% (market rate) plus about 0.625% in order to pay the same "no fees" price as the "best" borrower above.

That's just for a purchase loan. Homeowners with these credentials looking to do a cash-out refinance would face LLPA adjustments depending on the final LTV ratio of their loan. At at final 80% LTV, the "best" borrower would see 1.375% in fees (or an addition of about 0.375% to the base interest rate); for the second homeowner, as much as 5.125% in fees, raising the interest rate by perhaps 1.5%, and probably no longer making it worthwhile to do a cash-out refinance.

Loan-level risk-based pricing adjustments are added on top of one another, and with enough risks, things can get pretty pricey. by way of example, a borrower with a credit score below 639, making a 5% down payment, with a DTI ratio above 40%, buying a condo as an investment property using a agency jumbo ARM would see that same N% interest rate -- but also face up to 10.25% of the loan amount in fees to obtain that rate -- or, if those fees were traded into the interest rate, an interest rate of perhaps N% + 4 percentage points. If the N% market rate was 5%, this would make the loan's rate 9% at the same fee level as the "best: borrower above.

PMI costs are risk-based, too

Just in case you were wondering, other financial products have risk-based pricing, most notably insurance policies. This includes Private Mortgage Insurance, which takes into account your credit score, loan to value and debt ratios to arrive at policy premium costs. Like mortgages, there are base costs for the insurance, to which are added other risk-based increases, such as those for cash-out refinancing, second homes or investment properties. And of course, other kinds of insurance and lending products also charge different costs based on different risks, such as health insurance or credit card rates. However, as far as PMI goes, having more than one borrower on the loan can trim costs by just a bit.

Lenders have risks to manage as well

Other risk considerations can go into the cost of a mortgage. Lenders or investors have risks they must hedge, including what may happen to property values over a given period of time, how long a loan that they've made is likely to remain in place before being refinanced or repaid, and what future liabilities may be if they sell or retain a loan they've made. All can directly or indirectly affect the cost of a mortgage being made to a consumer.

With all these add-ons and add-ins that make up the price of a mortgage loan, one might ask: Doesn't raising the interest rate being offered actually make it somewhat more likely that a borrower would have trouble making payments, since they would be higher?

The answer is "No." Since these risks are identified, quantified and built into the price before the loan is made, the higher interest rate offered to the borrowers from the incorporation of risks into the price in turn reduces the amount of money the borrower can obtain, given a specific borrower income.

For example, if a borrower's income will support a $200,0000 mortgage with a no-risk rate of 6%, that same borrower's income might only support a $178,000 loan at a rate of 6.75% after risk-based increases are added. In both cases, the monthly principal and interest payment is $1,000 -- so there's no higher payment creating any additional strain on a budget.

In the end, risk-based pricing for mortgages using loan-level pricing adjustments (LLPA) are simply a means of trying to adjust the return to the lender or investor to match the risks of lending money. If you were lending your own money -- and you may well be if you have any investments that hold mortgage bonds -- you too would want to be better compensated for accepting greater risk.

As we noted way back at the beginning: Higher risks mean higher rates and fees. As a borrower, you'll want to present as few of them as you possibly can in order to get the lowest borrowing costs. To that we'd add that if there are unavoidable risks you should see if there are means available to offset or ameliorate them.