How Mortgage Lenders Assess Risk When Setting Interest Rates

When you apply for a mortgage loan, the lender will evaluate your financial situation to determine how much risk you bring to the table. Borrowers with a higher perceived risk typically receive higher mortgage rates, meaning they pay more over time.

• Assessing Risk: Lenders evaluate the likelihood that a borrower will repay a loan on time and in full. They do this by analyzing factors like credit score, debt-to-income ratio (DTI), employment history, and the loan-to-value ratio (LTV) of the property.
• Credit Scores: A lower credit score signifies a higher risk of default, or failure to repay. Borrowers with lower scores are statistically more likely to miss payments or default on the loan entirely.
• Debt Ratios: A high debt-to-income (DTI) ratio shows that a borrower is putting a large portion of their income toward their existing debts. This makes the loan riskier for the lender.
• LTV Ratio: A high loan-to-value (LTV) ratio, which results from making a smaller down payment, also increases risk for the lender. So borrowers who put less money down are typically charged a higher rate.
• Risk-Based Pricing: To compensate for the increased risk of lending to a borrower with weaker financial credentials, lenders charge a higher interest rate. This higher rate increases the lender's potential return and helps offset potential losses.
• Tiered Pricing System: Lenders often use a tiered pricing system where borrowers are grouped into risk categories based on their assessed risk. Each tier is assigned a different interest rate, with higher rates for riskier tiers.
• Risk-Based Pricing Notice: If a lender uses a credit report to offer less favorable loan terms, they are required to provide a risk-based pricing notice to the borrower.
• Loan-Level Price Adjustments (LLPAs): Many lenders use LLPAs, which are fees or rate adjustments tied to specific risk factors, such as a low credit score or high loan-to-value (LTV) ratio. These adjustments directly impact the borrower's mortgage rate.

A Deeper Dive Into Risk-Based Pricing

When deciding the interest rate to charge on a loan, mortgage lenders will use something known as risk-based pricing.

(Remember that phrase. You'll probably hear it again during the application process. 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 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, you'll learn some things you can do to appear less risky to a lender.

Risky Borrowers Receive Higher Rates

Imagine walking into a mortgage lender's office with a t-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/or a larger down payment ... you'll appear less risky and receive better pricing on the loan (interest rate).
• If you have bad credit, a higher debt-to-income ratio, and/or a lower down payment ... the lender will see you as a high-risk mortgage borrower. They'll charge you more interest as a result.

As you can see, it pays to be a low-risk borrower. It can help you qualify for a loan, and also helps you get a lower interest rate. The latter benefit could save you thousands of dollars over the life of your loan.

Two Borrowers, Different Risk Profiles

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 lender. Note the difference in the two mortgage payments, and the total interest paid over time.

Mortgage scenario #1

• Jessica uses a 30-year fixed-rate mortgage loan to buy a house.
• She takes out a loan in the amount of $250,000.
• She has an excellent FICO credit score of 805.
• The lender offers her their best interest rate of 5.4%.
• This is about the lowest rate for a mortgage at the time she applies.
• Jessica's mortgage payment will be about $1,400 per month.
• The total interest paid over the term of the loan is $255,377.

Mortgage scenario #2

• Sam is also using a 30-year fixed-rate mortgage to buy a home.
• Once again, the loan amount is $250,000.
• Sam barely "squeaks by" with a credit score of 598.
• As a result of his score, the lender assigns a higher rate of 6.9%.
• Sam's mortgage payment will be about $1,646 per month.
• Total interest paid over the life of the loan is $342,740.

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. So he will end up with a higher rate.

Key Factors That Can Affect Loan Pricing

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.

If you want to qualify for the best interest rates available, you'll probably need a credit score of 750 or higher (this varies). So by improving your score, you can reduce your total interest costs.

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 might pay a higher interest rate than someone buying a single-family detached home.

3. The Loan-to-Value Ratio

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% of the cost. So the loan-to-value ratio is 80%.

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. On the other hand, a lower LTV will reduce your interest costs.

4. 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.

A higher debt ratio will increase the cost of your loan. Statistically, it increases your chances of defaulting on the loan, putting you in a higher risk category. So the lender will likely charge you a higher interest rate.

How to Get a Lower Rate

These are not the only factors lenders use to determine your mortgage rate. But they are some of the biggest factors.

• 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.
• 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.
• Calculate 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, or even more? If so, you might want to reduce that ratio. It could improve your risk profile and help you secure a better rate.

Disclaimer: This information is provided for a general audience and might not apply to all situations. Mortgage rates, terms, and conditions vary widely based on a variety of factors. This article does not constitute financial advice.