Everyone knows there is a relationship between the cost of a mortgage loan and the borrower’s credit strength. The precise relationship, however, is less clear. Lenders expend a great deal of resources to determine the true cost of defaults so that their pricing is accurate on a risk adjusted basis. Level 1 Loans has examined seventeen of the largest lenders’ rate sheets to quantify the effect that credit scores and loan-to-values have on their pricing; all other product characteristics were held constant. We examined the pricing of a hypothetical loan with the following characteristics:
- $300,000 principal balance; 1st lien;
- 4.50% fixed rate coupon; 30 year term;
- Collateralized by property located in Ohio;
- Full documentation; conventional
We looked at pricing from our database of the major aggregators’ product offerings, underwriting guidelines, stipulations and rate sheets. This data is updated daily. The results (below) show a spread of 310 basis points between the highest price offered for this hypothetical loan (102.17 @ 60% LTV & 780 FICO) and the lowest (99.07 @ 95% LTV & 620 FICO). As can be seen, this is not a linear function. In fact, pricing is almost flat for FICOs >= 720 with LTVs >= 65%. Below this 720 threshold, however, the expectation of losses climbs and prices plummet.
Loss expectations are driven by the probability of default (PD%) and the severity of a projected loss, i.e. the loss given default (LGD%). While mortgage lending is a behavioral science, and many demographic factors relate to mortgagor defaults, we have limited this review to loan-to-value and credit scores. The PD% is primarily driven by credit score, while the LGD% is more a function of LTV; although the two are inextricably intertwined. Credit scores have minimal impact on pricing at the lower LTVs (62 bp swing @ 60% LTV) while they influence pricing by 285 bps at 95% LTV. Likewise, LTV variations have de minimus impact on pricing (26 bps) at credit scores over 720 but a 248 bp swing in pricing for the lower credit score mortgagors.
On a $300,000 loan, a swing in pricing of 310 basis points implies expected losses of approximately $9,300. This expected cost is passed onto the mortgagor in terms of either upfront points and/or a higher coupon.
For additional information please feel free to access our daily database of loan pricing indices (LPI) at www.L1Loans.com