Navigating the Mortgage Pricing Maze
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:
borrower’s credit score is below some critical level,
property will be rented rather than occupied by the
refinance, the borrower is withdrawing cash.
ratio of loan amount to property value is greater than
property is other than a single-family home.
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
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
Interest Rates on 30-Year Conforming FRM, March 26, 2013
No Other Risk Factors
*While lenders will go to 95, mortgage insurers will not
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
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
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
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
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
No Other Risk Factors
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
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)
760 and Higher
Less Than 680
90.01 to 95
85.01 to 90
80.01 to 85
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
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
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
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
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.