“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.
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. 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 in the highest tier, and often result in a pricing incentive.
Look at this example:
Fico score =>720 score = .375% rebate
Fico score 680-719 = no fee/rebate
Fico score 660-679 = .25% cost
As you can see, Fico scores of 720 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, while a cost is exactly the opposite.
Put simply, the more pricing rebates you have, the lower your interest rate should be. However, if your loan is riddled with costs, your 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.
So if a 6% mortgage rate has a base rebate of .625%, a 720 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 on your loan.
And if a bank or mortgage broker finds that the 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 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.
For more information related to risk-based pricing, see my page on mortgage pricing adjustments.
