Credit score predicts interest rate spread in home purchaseWhen lenders scrutinize numbers, higher scores translate into lower rates for buyers
Las Vegas Newspapers Mar. 26, 2006 When most people read mortgage papers, we see words. When lenders and others of their ilk do so, they see the numbers. That's because while the words explain how the loan works, the numbers explain why it is structured the way it is, at least to those who understand them. To those versed in economics, the numbers even spell out how good or how bad a credit rating the borrower had when the loan was made, no matter when it was made. Even more important, it reveals what the odds are that the borrower will default on the loan and lose the home. That's because every number has a meaning and a reason for being part of the loan. The numbers reflect the amount borrowed, down payment, the type and life of the loan, and the interest rate paid on the loan. It also includes how much the borrower owes to creditors, what other property the borrower owns, borrower income and credit score. Then there's the numbers that spell out the percentages of the payment that go to interest and principal every month for 360 months and how those percentages will change over the months, as well as taxes, insurance or any fees or assessments. Mike Fratantoni, a senior economist at the Mortgage Bankers Association in Washington, D.C., explained that the FICO score is one of the most important numbers in the mortgage formula, the one that determines how close the interest rate the borrower pays will be to the one that the lender advertised. That difference is sometimes referred to as "the spread," and the bigger the difference, the bigger the spread. "The FICO is a summary of credit history, and it is a pretty powerful predictor of a borrower's defaulting on a loan and lender. In order to maintain a sound business, lenders have to charge more to those with lower scores. That's because in the event of a default, there is enough misery to go around for everyone involved. The buyer loses the house. The lender loses money -- the principal and interest payments. It is really quite expensive and miserable for everyone," he said. So when a lender advertises a 30-year conventional mortgage at 6 percent, there are conditions attached, and the condition of the borrower's FICO score is one of them. That 6 percent is for people with what Fratantoni calls "an A-paper credit rating, a really great FICO." Sometimes a lender will actually state that the rates that appear apply only to those with a FICO score of "X" or better, but the borrower also needs a good down payment, a low debt-to-income ratio, enough income to make the payments, and so on. A-paper borrowers are also referred to as the "prime market," Fratantoni said. "In the prime market, borrowers have a good history and a strong down payment." As credit scores go down, however, interest rates go up, "and it's a fairly abrupt increase." While the 20-point difference between a 740 and 760 FICO score might be virtually nonexistent, the 20-point spread between 590 and 610 can be expensive, depending upon the lender and the other factors that go into the equation. Mortgages are rarely held by lenders. Most often, they are sold to investors in bunches, or "pools." The pools normally feature mortgages with similar FICO scores -- high FICO scores in one pool, not-so-high in another, slightly lower in a third, and so on. Most mortgages are sold to Fannie Mae, Freddie Mac or to private investors. "The people who buy them get the monthly mortgage payments, the principal and interest payments. Like all investors, they want the best return they can get for taking the risks they are taking," Fratantoni said. If a borrower defaults, the investors stop getting any money, either interest or principal. They will very likely recover at least some, if not the entire principal through the sale of the house, from private mortgage insurance, or from government-backed loans such as the ones from the Federal Housing Administration and Department of Veterans Affairs. This can take a while and investors lose income during that time. When lenders look at the long-term historical figures, they see that maybe 0.5 percent of prime borrowers, one out of 200, might wind up defaulting on a loan and going into foreclosure. "The long-term historical average for borrowers in the subprime market might be five to 10 times that," Fratantoni said. That makes a subprime borrower five to 10 times more likely to default, and the lenders and the people who buy the loans have to work that risk into their formula. The No. 1 indicator is the FICO. "A FICO is a bit like an SAT. An 800 is very good. A 500 is not good. You can see a direct relationship between the interest rate and the credit score in the pool." If the A-paper rate is 6 percent, and the average FICO score in the pool is 650 and above, the interest rate will be closer to 6 percent than those in a pool filled with loans in the low 600s. "When you start getting down to the lower 600s or 500s, that's where it's 7 percent or higher, maybe even 8 percent," Fratantoni said. "In the subprime market there is substantially more risk-based pricing. The implementation of risk-based prices has been responsible for the success and growth of the subprime market. We have lenders who can offer loans to people who might not get a loan otherwise. When lenders are allowed to charge more for a riskier borrower, lenders are more willing to extend credit." Stef Donev is a Southern California freelancer who writes for Interest.com and has been covering the mortgage industry and other consumer finance issues for nearly a decade. Interest.com is a national publisher of mortgage rates and information. 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