A High-Risk Mortgage is Going to Cost You
High-risk borrowers will have a hard time finding a mortgage loan in the post-recession economy. During the housing boom (which ended in 2008), lenders were offering loans to people with bad credit and shaky finances. Nearly anyone could qualify for a loan back then.
But the days of "easy credit" are over. We have entered a new era. In 2011 and beyond, high-risk mortgages will be extremely hard to find. In this article, we will examine the methods used by lenders to measure risk, and how it affects you as a home buyer.
How do mortgage lenders determine the interest rate you receive on your loan? And how do they decide how many points you need to pay at closing? Most of this comes down to the level of risk on the borrower's side. If the lender thinks you're a riskier borrower, they'll charge more.
Let's take a closer look at high-risk mortgages and how lenders price them:
Risk-Based Pricing Defined
When deciding the interest rate and mortgage points to charge on a loan, mortgage lenders will use something known as risk-based pricing. Remember this phrase. You'll probably hear it again during the application process, and repeatedly thereafter. You might even receive a risk-based pricing disclosure from your lender at some point.
Risk-based pricing is a model lenders use to review your mortgage application and financial background. The goal of this process is to determine how much of a risk you are, from a lending standpoint. They will adjust your interest rate and discount points up or down, based on this review process. So it directly influences the cost of your loan.
This is something you have control over, by the way. Later in this article, I'll explain what you can do to appear less risky to a lender.
Terminology: A discount point is a form of pre-paid interest. You can pay points at closing to lower the interest rate on your mortgage loan. If you stay in the home and keep the loan long enough, this might work out to your advantage. One "point" is equal to one percent of the loan amount (such as $2,500 on a $250,000 loan). Learn more
Mortgage lending is all about risk versus reward. I often tell home buyers to imagine themselves walking into a lender's office with a shirt that says "RISK" in big red letters. It's not far from the truth. That's how they'll look at you.
- If you have a high credit score, low debt levels, and a decent down payment ... you'll appear less risky and receive better pricing on the loan (interest rate and points).
- If you have bad credit, a higher debt-to-income ratio, and a lower down payment ... the lender will see you as a high-risk mortgage borrower. They'll charge you more in total interest as a result.
At this point, we can both agree that it pays to be a low-risk borrower. It helps you qualify for a loan, and it also helps you get a lower interest rate. The latter benefit could save you thousands of dollars over the life of your loan.
Here's a real-world scenario that shows two different borrowers. The second borrower has a much lower credit score, and therefore presents a higher risk to the borrower. Note the difference in the two mortgage payments, and the total interest paid over time.
The second scenario could be considered a high-risk mortgage loan. Sam's credit score suggests that he has had trouble repaying his debts in the past. Maybe he had some late payments on his credit reports, or even some debt collections or a previous foreclosure. Whatever the case, it sends a signal to the lender (via the credit score) that he's a bigger risk than John. Thus, he will pay a higher interest rate. He will probably have to pay additional points at closing, too.
Factors That Affect Your Interest Rate and Points
Lenders use many different factors when pricing your loan. Here are the three factors that carry the most weight:
1. Your Credit Score
Most lenders today will use your FICO credit score when considering you for a mortgage loan. There are other scoring models, but the FICO score is the most widely used in the lending industry. This is a three-digit number between 300 and 850. Your credit score is calculated based on the information in your credit reports. They are two different things, but directly related.
A higher score shows that you have managed your credit well in the past (i.e., you pay your bills on time). A low score suggests that you've had some trouble repaying debts in the past. Translation: a bad credit score will put you into a high-risk mortgage category, which means you'll pay more in interest.
If you want to qualify for the best interest rates available, you'll need a credit score of 740 or higher. So by improving your score, you can reduce your total interest costs. Here are some tips for doing just that.
2. The Property You're Buying
Certain types of properties represent a bigger risk for mortgage lenders. So they usually charge borrowers a higher rate of interest for such properties. Condos, investment properties and multifamily housing are the classic high-risk properties for lenders. On the other hand, a single-family detached home is statistically less of a risk.
With all other things being equal, a person buying a condo or an investment property will pay a higher interest rate than someone buying a single-family detached home. In most cases, anyway.
The loan-to-value ratio (LTV) will also influence your interest rate. This is a major risk factor for lenders. LTV is simply a comparison between the amount you're borrowing and the value of the property. For example, if you're borrowing $200,000 toward a home that costs $250,000, you are borrowing 80 percent of the cost. So the loan-to-value ratio is 80 percent.
The higher the LTV, the more risk there is for the lender. They are making a larger investment in the home. So they will charge more interest as a result. They will price the loan higher to make up for the larger investment they are making. On the other hand, a lower LTV will reduce your interest costs.
There's something else you should know about loan-to-value ratios. If your LTV is higher than 80 percent (meaning you are borrowing more than 80 percent of the home's value), you will have to pay mortgage insurance on the loan. This will increase the size of your monthly payments.
3. Your Debt Ratios
Lenders will also use your debt ratios to determine if you should be in a high-risk mortgage category. Your debt-to-income ratio is a comparison between your gross monthly income and the amount you spend toward your debts. You actually have two ratios.
- Your front-end ratio only includes your housing-related debt (i.e., mortgage payment).
- Your back-end ratio includes other types of debt as well, such as credit cards and car loans. Lenders are more concerned with the back-end ratio, which should ideally fall below 41 percent.
A higher debt ratio will increase the cost of your loan. It increases your chances of defaulting on the loan, statistically at least. So the lender will charge you a higher interest rate and points at closing. More money out of your pocket!
How to Get a Lower Rate
These are not the only factors lenders use to determine your mortgage rate. But they are three of the biggest factors. So if you want to lower your total interest costs on a mortgage loan, you should focus on these three things. Here's your task list:
- Find out what your credit score is, and improve it if necessary. This is one of the top-three factors used to determine your rate. Bad credit will almost certainly put you into the high-risk mortgage category. You can learn how to improve your score in this article.
- Save up enough money for a down payment. Most lenders these days will require a down payment of at least ten percent, though the FHA program allows for less. Putting more money down will reduce your loan-to-value ratio (LTV). This means less risk for the lender, and a better interest rate for you.
- Take a good, hard look at your debt ratios. How much debt are you carrying, in relation to your gross monthly income? Are you spending half of your income on debts? If so, you should reduce them. It will improve your risk profile and help you secure a better rate.
This article explains how mortgage lenders measure risk when making loans. If you would like to learn more about the home loan process, please use the search tool provided at the top of this page. You'll find a wealth of additional information on this topic.