Shrewd Mortgage Borrowers Know Their PNPs

October 5, 2009, Reviewed January 21, 2011

What Is a PNP?

PNP stands for “pricing notch point”, which is a value of one of the factors used in pricing at which the price changes. In most lines of business, the factor used to price is the quantity purchased. For example, at the farm stand where I buy corn, the price is $.70 an ear for the first 3 ears, $.65 for the next 3, and $.60 for any ears beyond 6. This merchant’s PNPs are 3 ears and 6 ears. These PNPs are pretty easy for consumers to understand, but the stakes are small.

In the mortgage market, PNPs are more complicated, but the stakes are high. On a mortgage, the "price" includes the interest rate, mortgage insurance premium and points, any or all of which can change in response to changes in loan size, loan-to-value ratio (LTV) and credit score. Each of these has its own PNPs.

Examples of Mortgage PNPs

As examples, on September 18, 2009 the interest rate on a 30-year prime FRM at zero points was 4.75% for a loan amount of $417,000, and 5.375% on a loan of $417,001. $417,000 was a loan-size PNP. On a prime 30-year FRM, the monthly mortgage insurance premium was .69% at an LTV of 85%, and .88% at an LTV of 85.1%. 85% was an LTV PNP. The same mortgage with a rate of 4.875% had points of .3% with a FICO score of 720, and points of .8% with a FICO of 719. 720 was a FICO-score PNP. 

On conventional loans, there are now 2 loan amount PNPs. One is $417,000, called the "conforming loan limit", which is the largest loan that can be purchased by Fannie Mae and Freddie Mac in any part of the country. The second PNP, called the “conforming jumbo limit” varies by county up to $729,750 and is scheduled to expire at the end of 2011.

PNPs in the ratio of loan amount to property value are generally 80%, 85%, 90%, 95% and 97%. In the crisis market that developed after the housing bubble burst in 2007, 75% also became a PNP.

FICO-score PNPs may differ some from lender to lender, but are equally important. A typical set would be 800, 780, 720, 700, 680, 660, 640 and 620.

Taking Account of PNPs In Selecting a Mortgage Borrowing Strategy

Since the increase in price that results from crossing a PNP applies to the entire loan, not just to the increment, the increment can be extremely costly. While no one would borrow $417,001, as in the example given earlier, they might borrow $500,000. In that case, the cost of the $83,000 increment would be 5.375% on the increment, plus an additional .625% on the $417,000. The moral is that you don’t pass a PNP in the wrong direction if you can possibly avoid it.  

PNPs often become relevant in connection with the issue of whether or not to finance closing costs, since doing so increases the loan amount and could breach a PNP. As an example, if closing costs on a $400,000 loan are $8,000 and the initial LTV is 80-83% of value, financing the closing costs won’t affect the price because the ratio will remain below 85%. But if the initial LTV was 84%, adding the $8,000 would bring the ratio above 85%, raising the price on the $400,000. That would make the cost of the additional $8,000 loan astronomical.

Another situation where PNPs are important to borrowers is where they have the capacity to make a larger down payment, or to pay down the balance preparatory to a refinance. If the larger down payment or prepayment penetrates a PNP, the return on investment will be very high. The financial crisis increased these returns by widening the price spreads between PNPs, and by eroding borrower equity.

As an example, a borrower who wrote me recently was paying 6.125% on her current mortgage and qualified for a no-cost refinance at 5.125%, which was highly advantageous. Because of the decline in the value of her home, however, her LTV had risen to 86%, which would require purchasing mortgage insurance on the refinance. To avoid that, she would have to pay down the loan balance by enough to reduce the LTV to 80%. Relative to remaining with her current mortgage, I calculated the annual rate of return on the required investment at 18% over 5 years and 16.6% over 30 years, with no risk. Equally high returns are available on modest-size investments in partial prepayments that convert jumbo into conforming loans.

Mortgage applicants are much more likely to be on the wrong side of a FICO-score PNP than an LTV or loan amount PNP because FICO-score PNPs are not as well known. Further, their loan provider may or may not be willing to put a deal on hold in order to work on an applicant’s credit score. Borrowers who have some leeway on timing should know their score before applying so that they have the option of delaying the loan while they work on their credit.

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