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Borrowers Should Try to Limit Risks

Why did Jones pay more for her mortgage than Smith? One possible reason is that her mortgage had features that increase risk to the lender, which charged a higher price to compensate. I call these “risk factors.” Potential borrowers ought to know what they are, how much of a rate penalty they will be charged when the risk factor is present, and whether or not there is any way to eliminate or reduce the penalty.

The major risk factors are:

∎ The borrower’s credit score is below some critical level, usually 740-760.

∎ The property will be rented as an investment rather than occupied as the borrower’s permanent residence.

∎ If a refinance, the borrower is withdrawing cash.

∎ The ratio of loan amount to property value is greater than 75-80 percent.

∎ The property is other than a single-family home.

∎ The borrower wants to avoid the escrow requirement.

The effect of these risk factors is measured by comparing interest rates with and without the factor on transactions that are otherwise identical. Readers can shop for mortgage rates among several lenders at my website, at http://www.mtgprofessor.com/ext/partners/shopyourloan2.aspx.

The borrower’s credit score is seen by lenders as a significant indicator of the borrower’s willingness to repay, and plays a significant role in mortgage pricing.

An important feature of risk pricing is that the price of one risk factor usually depends on whether or not there are other risk factors present. With this “risk layering,” there’s often a larger mortgage-rate spread between low credit scores and high scores when the transaction has another risk factor — for example, property used for investment rather than occupancy.

Borrowers can’t do anything about a poor credit score when they are shopping for a mortgage because all remedies take time. The quickest remedies, including the correction of mistakes in their credit file and reorganizing their credit card balances, require about three months. Improving a score by the gradual replacement of a poor payment record with a good record takes longer, perhaps a year or two, depending on how large an increase is needed. Recovering from a foreclosure or short sale requires a three- to four-year wait.

Properties that are the borrower’s principal residence are considered better collateral than rental properties. This is based on the premise that, if faced with a financial reversal, borrowers will exert greater effort to retain the house they live in than the house that they rent to someone else. Investment loans are therefore priced higher, and lenders also restrict the maximum ratio of loan amount to property value.

If the borrower is refinancing a mortgage on a rental property, it is clearly an investment transaction. Purchase transactions, on the other hand, are not so clear and depend on what the borrower plans to do. A borrower may purchase a house to live in, then change his mind and rent it. If he never occupies the house, he can be charged with fraud. If he lives in the house for awhile and then rents it, he is OK — everyone is entitled to change their minds. But don’t try it twice.

Consider this conversation between a broker and a consumer who recently called me. During the process of obtaining a loan from Amerisave, the property was determined to be non-owner-occupied, not owner-occupied as stated on the loan application. On page 4, under “Do you intend to occupy the property as your primary residence?” the consumer answered yes despite having an out-of-state driver’s license address. Now the consumer is mad because the appraisal fee has already been paid.

Broker: Well, do you occupy the property as your primary residence?

Consumer: No, but my daughter does.

Broker: Did you ever occupy the property as your primary residence?

Consumer: No, but we said we did when we bought it and that was fine with Bank of America.

Broker: So you got away with occupancy fraud when you purchased the property, but now you’re mad that you can’t get away with it again?

Consumer: Amerisave shouldn’t have done the appraisal if they thought we didn’t live there!

Broker: So you expect the file to be completely underwritten before they do the appraisal?

Consumer: Yes!

Broker: You should be grateful they didn’t call the FBI. Fraud on a government-guaranteed loan is a felony.