Risk-Based Mortgage Pricing

What Is Risk-Based Mortgage Pricing?

Risk-based mortgage pricing is a practice in which lenders present loan terms and conditions to individual applicants based on the lender’s assessment of the borrower's level of risk in regards to extending credit to that particular borrower.

Key Takeaways

  • Risk-based mortgage pricing is the practice of lenders offering loan terms and conditions to applicants based solely on their credit profile.
  • Lenders assess the riskiness of a borrower based on a variety of factors, such as credit score, and offer loan terms that are tailored specifically to that individual.
  • Borrowers with a strong credit profile will be offered better terms, such as lower interest rates, whereas borrowers with a poor credit profile will be offered harsher terms, such as higher interest rates.
  • Risk-based mortgage pricing benefits a lender as it allows them to charge higher rates to subprime borrowers, mitigating risks. It benefits subprime borrowers because they are able to buy a house whereas they may not be able to under standard loan terms.

Understanding Risk-Based Mortgage Pricing

Mortgage lenders offer varying interest rates and loan terms to different borrowers based on a grading of the creditworthiness of each borrower. Lenders grade borrowers and offer different rates and terms to them, based on several criteria, including the borrower's credit score, payment history, and the loan to value ratio of the mortgage. Risk-based pricing is commonly used by Alt-A and subprime lenders.

Risk-based mortgage pricing is similar to practices used by creditors of other types of loans, such as credit card companies and car loan financing lenders. These lenders will typically offer better deals and terms to applicants with better financial circumstances and credit histories. When making decisions involving the approval of loan or credit requests, these lenders gauge the risk that the borrower is likely to default or become delinquent on the loan, and then package their offers accordingly.

Borrowers who have had a bankruptcy or foreclosure, who have recently been unemployed, or who have had recent late payments or other credit issues will likely be offered a less attractive interest rate than borrowers with a more positive credit record.

This is standard practice, is completely legal, and is common in the financial industry. However, lenders cannot use legally prohibited factors in determining terms or making approval decisions for mortgage or credit applications. These prohibited factors include gender, marital status, race, and religion.

If a borrower is offered less attractive terms or rates based even in part on something found in their credit report, they will usually receive a notice informing them of the specific factors from their credit report that played a role in this decision.

Benefits of Risk-Based Mortgage Pricing

Risk-based mortgage pricing greatly benefits the lender because it protects them against default. The higher interest rate charged to borrowers with lower credit quality makes up for the increased risk of lending them money. The practice also benefits borrowers with a good credit history because it allows them to obtain mortgages at low prices.

Risk-based mortgage pricing also helps individuals with a poor credit history to be able to buy a house where they may otherwise not have been able to do so based on their poor credit score or other limiting factors. Because a high-risk borrower can be charged an interest rate above the standard rate, a bank will be more comfortable lending them money to buy a house.

This would then improve the financial condition of the borrower as they will have equity in a home, and if they are able to furnish their mortgage payments without issue, it will eventually improve their credit history.

Of course, this can backfire as well, as it did in the subprime meltdown that led to the 2008 financial crisis. Subprime borrowers who had extremely poor credit were given mortgages, which at some point they were not able to make payments on and defaulted.

Risk-Based Mortgage Pricing Expanding Credit Options

Risk-based mortgage pricing has expanded the types of mortgages lenders can offer and has increased the number of borrowers that can generally qualify for a mortgage.

Alt-A and subprime mortgages, the types of mortgages generally subject to risk-based pricing, are frequently sold by the mortgage originator into the secondary mortgage market, where they typically become part of collateralized mortgage obligations (CMOs), asset-backed securities (ABSs), and collateralized debt obligations (CDOs).

Risk-based pricing plays a large part in the structuring of CMOs, ABSs, and CDOs, enhancing their overall credit rating and making them attractive to a wide range of investors.