For the past few years getting a real estate loan has been fairly easy. The reason has little to do with interest rates or credit reports; instead investors who provide the cash used for mortgages have been looking at risk versus reward. For them the question has been: Would you accept a few additional foreclosures among thousands of loans if your overall portfolio produced a better rate of return?
The result, according to the Federal Reserve, is that mortgage applicants “who are less creditworthy or who are unwilling or unable to document their creditworthiness or income are increasingly less likely to be turned down for a loan; rather, they are offered credit at higher prices.”
In other words, woeful credit is no longer a barrier to getting a mortgage. Even borrowers with terrible credit are able to get financing if only they’re willing to make bigger payments.
“The idea of risk-based pricing in real estate really started with appraisals,” says James J. Saccacio, chief executive officer of RealtyTrac, the largest marketplace for foreclosure properties. “It used to be that every mortgage required an appraisal if one had not been done during the past six months. But a few years ago, a new idea emerged: Why have an appraisal when the value of most homes was pretty well known?”
Lenders, after all, have extensive records regarding the loans they’ve made. In many states, sale and value information is freely available from assessment and property tax offices. If you stick all the data in a computer and run the numbers using automated valuation models (AVMs) you can get a good idea of local home values. In fact, the more valuations you run the better the system gets over time.
What an AVM can tell is the statistically-indicated value of a home. However, if the valuation is wrong and the property is foreclosed, that isn’t much of a financial problem for a lender with 25,000 or 50,000 loans.
First, a foreclosed property is worth something rather than nothing. There are many cases where a home is a complete loss.
Second, the difference between the sale price of a foreclosed property and the first-loan balance is often covered in part or in whole by insurance from either the federal government for VA and FHA loans or by private mortgage insurance (PMI) for conventional loans.
Third, while the loss of a home to foreclosure is a life-changing event to an individual owner, in statistical terms the lender’s financial risk is off-set by thousands of loans. A foreclosure here or there will not bankrupt a lender.
Because the mortgage marketplace is highly competitive, lenders cannot simply charge more for all loans. Instead they compete today by micro-pricing, offering loans at different rates and terms for individual borrowers.
For lenders “risk-based pricing” means that each borrower is evaluated individually and then offered a loan which minutely reflects their specific credit standing. It also means that Lender Smith may well offer a different rate when compared with Lender Jones. Even though both have the same data they may each have a different level of risk acceptance. Because lenders have different views of risk and reward, borrowers with a given credit rating can routinely find different rates, terms and programs by shopping around.
To see how “risk-based pricing” works, imagine that the “par” interest rate for a loan is 6.5 percent — the “par” rate is the interest level without points. Some combinations of rates and credit might look like this:
· A borrower with a sold credit score, say 720 or better, might get the 6.5 percent par rate.
· A borrower with weaker credit and a score of 650 might pay 7.2 percent plus 2 points or perhaps 7.4 percent and no points.
· A borrower with great credit, say someone with a score above 800, might pay 6.3 percent and no points. In effect, this borrower gets a substantial benefit for good credit.
· The borrower with great credit and that 800 score might pay 6.5 percent — but the lender in this situation may pay some or all of the borrower’s closing costs.
Not only can lenders adjust interest rates according to risk, they can also adjust mortgage insurance premiums.
For instance, in July 2006, the U.S. House of Representatives passed H.R. 5121, the gloriously-named “Expanding American Homeownership Act of 2006.” The legislation was designed to modernize the FHA loan program. A companion Senate bill, S. 3535, was introduced, but did not pass.
If enacted into law the legislation would eliminate the current insurance premium caps — as much as 2.3 percent upfront plus .55 percent annually — that now apply uniformly to all FHA borrowers. Instead, the legislation would allow the FHA “to raise or lower the premium to match the borrower’s risk.” The result is that FHA borrowers would pay market loan rates while FHA exposure would be reduced because riskier borrowers would pay higher insurance premiums.
In this situation, borrowers might qualify for a lower interest rate or bigger loan amount if they accept a higher mortgage insurance premium. Since insurance is a smaller cost than interest, this might be a good trade for many borrowers.
To this point risk-based pricing has given more borrowers access to a wider range of mortgages than might otherwise have been the case. However, the system is based on mathematical models and has largely functioned in a marketplace defined by rising values and relatively-low interest levels.
“How well risk-based pricing will function in a slower market or in a market with steeper interest rates is unknown,” says RealtyTrac’s Saccacio. “We may find that the models work very well in good times but that they produce huge numbers of foreclosures when interest rates rise or home sales decline. Especially in situations that involve interest-only financing and option ARMs — loans with low monthly costs up-front and perhaps far-higher costs in the future — we may discover that risk-based pricing is more risky than anyone expected. Now is the time to refine lender models, to make them more conservative, so we can reduce potential foreclosure rates.”
Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 90 newspapers.