Mortgage Rate Risk Factors
STUDIES CONFIRM RISK FACTORS DRIVE MORTGAGE LOAN PRICING
The interest rate a borrower pays on a mortgage loan is directly related to his or her credit risk profile, according to two new studies commissioned by the law firm of Sirote and Permutt P.C. of Birmingham, Alabama at the request of the National Home Equity Mortgage Association (NHEMA). The studies, authored by Professors Richard F. DeMong and James E. Burroughs of the University of Virginia's McIntire School of Commerce, are based on a detailed analysis of approximately 1 million mortgage loans made in all 50 states and the District of Columbia during 2004 by multiple lenders that specialize in nonprime mortgage lending.
"The question of how certain risk factors and the presence of prepayment fee clauses affect mortgage pricing came up when I testified at House of Representatives Financial Services Committee hearings last year," said Professor DeMong. "I had to admit I didn't know of any hard data on these issues that could help the Committee members. That's when I started moving forward on these studies. They directly address the vital questions ? is the mortgage market efficiently pricing loans based on risk? Are prepayment fee clauses on loans an option that really benefits consumers? Those questions go to the heart of informed consumer choice and effective policymaking."
To answer these questions, professors DeMong and Burroughs looked at a range of borrower characteristics on a huge number of loans, and found that the level of risk these characteristics represented, along with the presence of a prepayment fee clause, directly related to the price the borrower paid for the loan, as measured by annual percentage rate, or APR. Higher credit ratings and a borrower's willingness to accept a prepayment clause translated into lower interest rates.
Specifically, the analysis by Professors DeMong and Burroughs found that:
The higher the FICO score the lower the interest rate on the loan. FICO scores, which measure risk based on a consumer's financial history, have the largest influence on mortgage prices. On average, each 10-point increase in a borrower's FICO score reduces the APR on the loan by 10 basis points (or 0.10 percent).
Borrowers with more secure income pay less. Borrowers who can fully document their incomes pay lower APRs on their mortgages than borrowers who supply only "stated income" to lenders.
Buyers who live in their homes pay less than those purchasing property for rental or other investment. Prices are generally less for mortgages on homes the borrower plans to occupy than on non-owner-occupied homes ? the average APR for owner-occupied homes is 62 basis points (or 0.62 percent) less.
Borrowers who use less home equity, that is have lower loan-to value generally pay less for their loans. On average, for every one-percentage-point increase in LTV, the APR increases by 0.6 basis points (or 0.006 percent).
Prepayment Fee Clauses Lower Loan Rates
Regarding prepayment fees, the studies found that borrowers pay less for mortgage loans that include prepayment fee clauses (in which they agree to pay a small fee if they pay off or refinance their loan before a certain amount of time has passed; usually two or three years). On average, a loan with a prepayment fee has an APR 38 basis points (or 0.38 percent) lower than a loan with no prepayment fee. Furthermore, the studies found that borrowers with higher FICO scores are actually more likely to opt for a prepayment fee than borrowers with lower FICO scores.
"Professors DeMong and Burroughs have performed an invaluable service," said NHEMA President Jeffrey Zeltzer. "Their studies bring a new level of transparency to mortgage pricing, giving consumers vital information about what factors affect mortgage prices and how. NHEMA has long worked to give consumers the tools and information they need to make smart mortgage borrowing choices. These studies represent a major step forward in consumer education and awareness."
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