“Risk-based pricing” is a method the mortgage industry uses to measure risk and deliver appropriate interest rates based on a borrower’s ability to repay their loan. To mitigate the risk of default, banks and mortgage lenders have created pricing adjustments for a variety of loan criteria.
In simple terms, a borrower deemed more risky by a bank or lender will receive a higher mortgage rate to offset the greater probability of default.
Conversely, a more qualified borrower will be granted a lower interest rate seeing that there’s a smaller chance of them actually missing a mortgage payment.
Less Risk = Lower Mortgage Rate
There are a number of risk-based factors that can affect the pricing of your loan.
One of the most important factors will always be credit. Fico scores range from 300-850, and can greatly impact the interest rate you ultimately receive. Scores of 760 and above are generally considered to be in the highest tier, and often result in a pricing incentive.
Look at this example of risk-based pricing:
Fico score =>760 score = .375% rebate
Fico score 680-719 = no fee/rebate
Fico score 660-679 = .25% cost
As you can see, Fico scores of 760 and above receive a “rebate” of .375%, while scores between 660-679 are slapped with a .25% “cost.” These costs or rebates associated with each rate are known as adjustments to fee. A rebate is a good thing because it means the borrower or loan originator is getting money back for doing your loan, while a cost is exactly the opposite.
Put simply, the more pricing rebates you receive, the lower your interest rate should be. However, if your loan is riddled with costs for things like a lower credit score, your mortgage rate will be higher to compensate.
Note that credit scores between 680 and 719 weren’t assigned a cost or a rebate because they’re all in all pretty average.
More Risk = Less Commission
So if a 6% mortgage rate has a base rebate of .625%, a 760 Fico score would raise the rebate to 1%, and a score between 660-679 would lower the rebate to .375%. This net rebate is the actual yield spread premium (or commission) the broker or bank will receive for closing your loan.
In other words, a borrower with a higher Fico score will be able to secure more commission for the loan originator, so they won’t need to pay as much (if anything) upfront.
Conversely, if a bank or mortgage broker finds that their commission isn’t adequate because of excessive adjustment costs associated with your loan, they will likely have to raise your interest rate to collect a higher rebate. Or you’ll be charged a greater number of upfront mortgage points.
In summary, the more costs associated with your loan, the less rebate your broker or bank will be left with, and the higher the mortgage rate will have to be to ensure they get paid to fund your loan. That is, unless you agree to pay for the loan costs upfront instead. Either way, the more risk you present to the lender, the more you must pay. Period.
For more information related to risk-based pricing, see my page on mortgage pricing adjustments.