Freddie Mac is reporting interest rates of 5.62 percent for a fixed rate 30 year
loan and Fannie Mae says it's about the same.
So how come your lender just quoted you 7.25 plus 2 points?
It's all about risk.
A lender wants a certain amount of assurance that, if he lends out 100,000
he is going to eventually get 100,000 back, plus interest. It might take 30
years to recoup all of that money although more and more people are selling
houses or refinancing mortgages in a much shorter timeframe, but the idea is
that the loan will eventually be repaid.
Lenders assess mortgage risk
- the borrower's track record in paying back money
- the borrower's ability to continue to pay his obligations in the future
- the borrower's investment in the collateral
- and the underlying value of the collateral itself
In other words:
- credit history
- debt to income ratio
- amount of down payment
- and the appraised value of the car, jewelry, stocks, or real estate that secures
It is a basic premise of lending and mortgage qualification that high
risk loans have higher interest rates. A golden borrower, one with
excellent credit, low debt to income ratio, and a substantial
down payment is a borrower who presents little risk and thus usually gets an
interest rate like those that are advertised in the paper and on-line. A borrower
with a sketchy credit history (and it doesn't take much to turn excellent into
sketchy when it comes to credit) a combination of high debt and insufficient
income, and a low down payment is going to raise lender eyebrows and lenders
are going to raise the interest rates and fees charged for the loan.
None of this should come as a surprise to anyone who has bought a house or
a car. A new study, however, has identified other factors that contribute to
a high interest rate and has actually quantified the impact of some of these
factors on the rate.
The study "Mortgage Pricing is Based on Risk" was carried out by Richard
F. DeMong and James E. Burroughs of the McIntire School of Commerce, University
of Virginia on behalf of the law firm of Sirote & Permutt, P.C. of Birmingham,
DeMong and Burroughs examined 961,344 mortgage loan applications made in 2004
trying to confirm that interest rate (measured in this case by APR) is tied
to risk and which factors are considered as part of risk. They looked at FICO
(credit scores), Loan to Value (LTV) and income, but they also weighed such
factors as whether the home would be owner occupied, the type of lien (1st of
2nd mortgage) whether the application was full income verification or stated
income mortgage loans and, the inclusion or omission of a prepayment
fee in the final mortgage. Interestingly enough, they did not study the impact
of debt or income to debt ratio except to the extent that it is factored into
the FICO score.
The pair found that all of the risk factors they studied did have a positive
correlation with APR. The strongest impact, as might be expected, was the type
of lien. Even though borrowers in the study who were applying for 2nd mortgages
had, overall higher FICO scores than those who were applying for 1st mortgages,
the APR for second liens was found to be 253 basis points (2.5 percent) higher
than for first liens due to the greater risk that full recovery might not be
made on the collateral.
Where borrowers provided full income documentation to their lenders
they received an APR that was, on average, 14 basis points lower than the borrowers
who used the "stated income loans" option; that
is did not provide any type of verification or documentation of the income they
claimed to have.
Because of the proven impact of lien position and income verification, the
study then focused only on 1st mortgages that had full income documentation
in order to isolate the effect of FICO scores, LTV, income, prepayment fees
and owner occupancy.
The study found that FICO scores had a beta of .010 which means that for each
10-point increase in the FICO score there was a corresponding decrease in borrowers'
APR of 10 basis points with all other factors held constant. Since the lowest
APR's went to those with FICO scores of 720 or higher, one can pretty
easily calculate the effect that his own FICO score will have on his rate.
Likewise, both LTV and monthly income were significantly related to APR. The
average LTV for the first liens studied was 78 percent. When LTV increased one
percent the APR went up slightly less than one basis point - 0.6 basis points
to be precise. This, however, was mitigated a bit by FICO scores. Lenders seemed
willing make bigger loans with higher LTVs to borrowers with higher credit scores
The study estimated that APR declined 2.3 basis points for every thousand dollar
increase in monthly income, but no baseline information was given.
The threat of an early payoff is considered a risk factor by many lenders.
"Lenders are able, and do, offer loans with lower APRs to borrowers who are
willing to accept a prepayment fee as a conditions of the loan…..because
participants in the secondary market prefer loans with a more certain prepayment
schedule and will pay a higher price for a package of mortgage loans with a
prepayment fee as a result." Prepayment penalties for mortgage
loans are illegal in the majority of states; nonetheless prepayment fees were
included in 69 percent of the mortgages studied. Where such penalties were written
into the loans, first mortgages had an average reduction in APR of 38 basis
point and second mortgages 14 basis points. This reduction was found regardless
of the borrower's FICO scores.
Not surprisingly, the owner-occupied status of a home had significant impact
– first mortgage loans to borrowers for vacation homes or business investment
had an APR 62 basis points higher than those which were to be owner occupied.
While the summary conclusion of the study "The greater the risk to the
lender, the higher the APR charged for making the loan" seemed pretty
obvious already, it is interesting to have some numbers attached to those risk