credit score, mortgage risk, cash-out refinance, LTV, waive escrow, investment property, 2-4 family homes

Navigating the Mortgage Pricing Maze
April 29, 2013

Why did Jones pay more for her mortgage than Smith? One possible reason is that her mortgage had features that increase risk to the lender, who charged a higher price to compensate. I call these “risk factors.” Potential borrowers ought to know what they are, how much of a rate penalty they will be charged when the risk factor is present, and whether or not there is any way to eliminate or reduce the penalty. That is the subject of this article. 

Risk Factors and Their Measurement

The major risk factors are: 

1.    The borrower’s credit score is below some critical level, usually 740-760.

2.    The property will be rented rather than occupied by the borrower.

3.    If a refinance, the borrower is withdrawing cash.

4.    The ratio of loan amount to property value is greater than 75-80%.

5.    The property is other than a single-family home.

6.    The borrower wants to avoid the escrow requirement. 

The effect of these risk factors is measured by comparing interest rates with and without the factor on transactions that are otherwise identical. The rates cited below cover “conforming” loans that are eligible for purchase by Fannie Mae and Freddie Mac, and have been adjusted to include all loan fees. They were obtained by shopping for a 30-year fixed-rate mortgage, the most widely used of the various mortgage types, at the 6 lenders who price mortgages on this site. In every case, the rates shown are the lowest of those posted by the 6 lenders. Readers can do the same at /ext/partners/shopyourloan.aspx.  

Low Credit Score

The borrower’s credit score is viewed by lenders as a significant indicator of the borrower’s willingness to repay, and plays a significant role in mortgage pricing. The table below shows the rates for the three credit scores that are used most widely by lenders in their pricing.   

Interest Rates on 30-Year Conforming FRM, March 26, 2013

Fico Score

No Other Risk Factors

Investment Property

Interest Rate

Maximum Loan-to-Value

Interest Rate

Maximum Loan-to-Value

740

3.44%

95%

3.75%

75%

660

3.88

95

4.15

75

620

4.14

80-95*

4.88

75

*While lenders will go to 95, mortgage insurers will not accept 620. 

An important feature of risk pricing is that the price of one risk factor usually depends on whether or not there are other risk factors present. This “risk layering” is illustrated in the table by the larger rate spread between low-scores and high-scores when the transaction has another risk factor – in this case, property used for investment rather than occupancy. The rate spread between the highest and lowest credit scores is .68% when there are no other risk factors present, but it is 1.13% on investment transactions. 

Can Borrowers Influence Their Credit Score? They can’t do anything about a poor credit score when they are shopping for a mortgage because all remedies take time. The quickest remedies, including the correction of mistakes in their credit file and reorganizing their credit card balances, require about 3 months.  Improving a score by the gradual replacement of a poor payment record with a good record takes longer, perhaps a year or two, depending on how large an increase is needed. Recovering from a foreclosure or short sale requires a 3 to 4-year wait. 

 Property is an Investment Rather Than Occupied by the Borrower

Properties that are the borrower’s principal residence are considered better collateral than properties that are rented. This is based on the premise that, if faced with a financial reversal, borrowers will exert greater effort to retain the house they live in than the house that they rent to someone else. Investment loans are therefore priced higher. As shown in the table above, lenders also restrict the maximum ratio of loan amount to property value when the property is for investment. 

Can Borrowers Influence The Type of Occupancy? Obviously they can, since it is the borrower’s decision whether to occupy a property as a primary residence or rent it out. The lender will infer the borrower’s intentions from the circumstances of the transaction.  

If the borrower is refinancing a mortgage on a rental property, it is clearly an investment transaction. Purchase transactions, on the other hand, are not so clear and depend on what the borrower plans to do.  A borrower may purchase a house to live in, then change his mind and rent it.  If he never occupies the house, he can be charged with fraud. If he lives in the house for awhile and then rents it, he is OK -- everyone is entitled to change their minds. But don’t try it twice.  

Cash-Out Refinance

Borrowers who withdraw cash when they refinance are viewed as riskier than those who don’t, because the cash withdrawal indicates a lack of other resources, and possible financial distress. As shown in the table below, the rate on cash-out deals is higher than on no-cash deals that are otherwise identical. The price difference is particularly large when the borrower’s credit score is low, which is another illustration of what is called “risk layering”. 

Interest Rates on 30-Year Conforming FRM, March 26, 2013 

Credit Score

No  Other Risk Factors

Cash-Out Refinance

740

3.44%

3.75%

660

3.88

4.15

620

4.14

4.88

 Note that refinancing borrowers can increase their loan balance by enough to cover their settlement costs without the loan being classified as “cash-out”. The borrower must literally walk away with cash for the transaction to be “cash-out”. 

Borrower Control Over Cash-out: Whether or not cash is withdrawn is entirely within the borrower’s discretion. But many use the discretion unwisely because they under-estimate the cost of the money they take out of the refinance. They view the cost as the rate on the new mortgage, ignoring the higher cost on the existing loan balance.  

For example, using the rates in the table above, consider the borrower with a credit score of 620 who could refinance a $240,000 balance at 4.14% but instead refinances $254,000 at 4.88% in order to get $14,000 in cash. The interest cost of the $14,000 is not 4.88% because this ignores the .74% of additional cost the borrower must pay on the $240,000 balance. If this additional cost is added in, as it should be, the borrower is paying 15.24% rather than 4.88%. At that rate, there could be much better options for raising cash than the cash-out.  

Note that a cash-out deal raises the ratio of loan amount to property value (LTV). If the borrower must pay a higher mortgage insurance premium at the new LTV, the cost of the cash taken out would be raised even more. The LTV is a critically important risk factor that is considered next.  

High Loan-to-Value Ratio (LTV)

The mortgage interest rate is not usually affected by the LTV but if the ratio is above 80, the borrower must pay for mortgage insurance. The insurance premium rises with the LTV, and is also subject to the same risk factors as the mortgage rate. Borrowers with low credit scores, for example, will pay higher mortgage insurance premiums as shown below. 

Mortgage Insurance Premiums on 30-Year FRM, March 26, 2013
(Annual Premium Rates Paid Monthly)

Loan-to-Value Ratio

Credit Score

760 and Higher

720-759

680-719

Less Than 680

90.01 to 95

0.59

0.67

0.94

1.20

85.01 to 90

0.44

0.49

0.62

0.76

80.01 to 85

0.28

0.32

0.38

0.44

Borrower Control Over LTV: Borrowers should be aware of the LTV categories shown in the table, which I call “pricing notch points” or PNPs. If they intend to finance their closing costs, and especially if they  intend to take cash out, they should make sure that this will not breach a PNP and raise their cost. If they find that their loan amount is just above a PNP, say 85.1, they should beg or borrow the amount needed to reduce the loan amount to the lower price bracket. It would be a very high yield investment.  

Borrowers with LTVs above 80 should make sure that they are not paying more than necessary for mortgage insurance. You can check the premium quoted to you by your lender at /ext/partners/shopmortgageinsurance.aspx.  While there, you can also check whether or not you might do better with a financed single-premium plan, as opposed to the monthly premium plan shown in the table. Most lenders only quote monthly premiums, even though in some cases the single premium plan would be less costly to the borrower.   

Properties Other Than Single-Family Houses

Borrowers pay more for their mortgage if the property is other than a single-family unit. A 2-unit property where the borrower will occupy one of the units will be classified as a primary residence rather than an investment, but because the second unit is likely to be rented, from a lender perspective it has some of the drawbacks of an investment property. Many tenants don’t take care of their properties as well as owners, even when the owner lives next door.  

On 3 and 4-unit properties, lenders view the risk as even greater, and as shown in the table below, they charge more than on a 2-unit property. Further, at LTVs higher than 80, they won’t make loans on 3 and 4-unit properties.  

Interest Rates on 30-Year Conforming FRM, March 29, 2013

Type of Property

LTV 80%

LTV 85%

Single Family

3.51%

3.54%

2-Family

3.58

3.58

3-Family

3.68

Not Available

4-Family

3.68

Not Available

Condo

3.57

3.61

 Condominium mortgages may or may not cost more than a mortgage on a single-family unit, depending on the LTV and the financial as well as physical condition of the condominium project. The owners of condominium units face a risk that owners of single-family units do not have. They are responsible for maintenance of the grounds and buildings, which means that the failure to pay condo fees by some owners imposes a greater financial burden on the others. Ordinarily this is not a problem, but it has become a problem in some projects in recent years. 

If condo fee defaults in a project become too high, lenders may refuse to make any loans on units in that project. I have received some anguished letters from condo owners unable to refinance or to sell because of such a lender freeze.  

Borrower Control Over Property Type: Borrowers with 2-4 unit houses can’t do anything to control the mortgage price except to shop carefully. Prospective condo purchasers, on the other hand, can and should assess the risk posed by the condo project by examining its financial status, with particular emphasis on condo fee defaults by existing condo owners.  

Waiver of Escrow

Lenders generally require borrowers to include taxes and insurance premiums in their monthly mortgage payments, which are placed in escrow until the payment date when the amount due is paid by the lender. Mortgages are priced on that assumption. If you want to control the taxes and insurance yourself, you can request a waiver of escrow which will cost you about ¼ of a point – that is $250 for each $100,000 of loan amount.

Borrower Control of Escrow Waiver: This is entirely within the borrower’s discretion. I didn’t waive escrow on either of my mortgages because I like to keep my life as simple as possible, and adding a set amount to my mortgage payment every month to cover taxes and insurance was as simple as it got. The borrowers who waive escrow are either control freaks, or they fear that the lender will screw it up, which occasionally happens. When it does it can be a nightmare for the borrower. I was not deterred by this risk, however, because I felt that the risk that I would screw it up was greater.

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