Approving mortgages is all about assessing risk, as underwriters scrutinize every detail and shred of data in hopes of accurately predicting if a potential borrower will pay their mortgage on time every month – or default.
That’s good news for consumers that are good stewards of their financial affairs since keeping a great credit score, a low debt load, and plenty of assets will help them get approved for the best low-rate mortgage loan when it comes time to refinance or purchase their next home.
But many people don’t realize that there is an additional level of reward for good borrowers, as mortgage finance giant Fannie Mae prices risk into their interest rates using a system called “loan-level pricing adjustments” or just LLPAs. This risk-based pricing model
Quite simply, the more risk factors, the higher the pricing the mortgagee will face. It may seem like LLPAs act like additional fees, but the additional cost is built into the loan pricing so the borrowers usually doesn’t pay out of pocket, just in the form of higher interest rates or built-in buy-downs.
An ancillary effect of loan level pricing is that since pricing/rates are higher for higher-risk borrowers, there is less margin for mortgage brokers to charge a fair fee or commission, so essential everyone loses.
What kind of risk factors does Fannie Mae “flag” with their risk-based pricing model? LLPAs typically charge more if a borrower has lower credit scores, a high Loan-to-Value ratio on the property (low down payment), and if it’s an investment property and/or multi-unit property.
We’ve included a sample matrix that shows the “hits” for certain risk factors based on LLPAs – but please note these are for educational purposes only and may not be accurate.
You’ll see that there are several price hits for low credit score and high LTV combinations. For instance, with a 95% LTV loan where the borrower only puts down 5% on a property, there is a 3.000% hit for borrowers with credit scores less than 620. But once a borrower reaches a 740 credit score and higher, that hit goes away. That means that based on LTV and credit score alone, a borrower with a credit score of 620 or less will pay a charge of 3% of the loan amount to get the same interest rate as a borrower that has a credit score of 740 or higher.
In terms of actual dollars, that means on a $200,000 loan the borrower with a credit score lower than 620 would pay an additional $6,000 buy down fee to get the same interest rate as the borrower with the 740 score.
There are also big hits with LLPAs if the property being lent against is an investment property instead of a primary residence, as data shows the risk is higher. Research also shows that the smaller the down payment a home buyer puts down, or the lower the value versus loan amount on a refinance (LTV), the higher the risk of default for the lender and Fannie Mae, and therefore the higher the adjustment.
It’s easy to see that a huge part of Fannie Mae’s risk based pricing model has to do with credit score. LLPAs are pretty significant when a borrower has a credit score in the mid to high 600s (which is considered mediocre or average but not a poor credit score), unless there’s a compensating factor that the Loan-to-Value is 60% or less.
But risk-based pricing adjustments can benefit borrowers, too. With FICO scores ranging from 300 to 850, it’s borrowers with scores of 760 or above will usually be considered the safest mortgagees and therefore will get pricing incentives based on LLPAs. Credit scores between 680 and 719, while considered good, won’t receive any adjustment to pricing, positive or negative.
The bottom line is that like anything, it really pays to keep a great credit score as part of your total financial picture. With Fannie Mae’s Loan Level Pricing Adjustments, a great credit score can save you a whole lot of money when it comes time to get approved for a mortgage!
