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 their level of risk in extending credit to that particular borrower.

Mortgage lenders offer varying interest rates and loan terms to different borrowers based on a grading of the credit worthiness of each borrower. Lenders grade borrowers, and offer different rates and terms to borrowers, 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.

BREAKING DOWN 'Risk-Based Mortgage Pricing'

Risk-based mortgage pricing is similar to practices used by creditors of other types, 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 other borrowers with a more positive credit record. This is a 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 or 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.

Risk-based mortgage pricing expanding credit options

Risk-based mortgage pricing has expanded the types of mortgages lenders offer and 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, asset backed securities and collateralized debt obligations. Risk-based pricing plays a large part in the structuring of CMO, ABS and CDO, enhancing their overall credit rating and making them attractive to wide range of investors.