Risk-based pricing
“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 a 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 interest rate to offset the greater probability of default. After all, it makes perfect sense to give the more qualified borrower the better rate.
There are a number of factors that can affect the pricing of your loan. One of the most important factors will always be credit. Credit scores range from 300-850 (credit score range), and can greatly impact the interest rate you ultimately receive. Scores of 720 and above are generally considered to be the highest tier, and often result in a pricing incentive.
Look at this example:
Fico score >720 score = .375% rebate
Fico score 660-679 = .25% cost
Note that scores between 680 and 720 weren’t used, and aren’t assigned a cost or a rebate. However, scores over 720 received a rebate of .375%, while scores between 660-679 were slapped with a .25% cost. These costs or rebates associated with each rate are known as adjustments to fee. Fee is another name for rebate, or yield spread premium.
So if an interest rate of 6% has a base rebate of .625%, a 721 fico score would raise that base rebate to .875%, and a score between 660-679 would lower that base rebate to .375%. This net rebate is the actual yield spread premium (YSP) the broker or bank will receive on your loan.
And if a bank or mortgage broker finds that the YSP 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. So the more costs associated with your loan, the less rebate your broker or bank will be left with, and the higher the rate will be to ensure they get paid to do your loan. That is, unless you agree to pay for the loan costs upfront instead.
For more information related to risk-based pricing, see my page on mortgage pricing adjustments.
