JUNE 2004

Risk-Based Pricing on Subprime Mortgages

One of the criticisms frequently heard about the subprime mortgage industry is that "predatory" lenders take advantage of less sophisticated borrowers (e.g., recent immigrants, minorities, the elderly) by overpricing the loans relative to the borrower's risk. A recent study conducted by the mortgage industry newsletter Inside B&C Lending (Bethesda, MD) found evidence that subprime mortgage borrowers do receive loan pricing that reflects their underlying credit risk. In its analysis, the study examined the relationship between borrower FICO scores and loan interest rates on $4.64 billion in subprime mortgages included in recent securitization deals from Ameriquest Mortgage, New Century Financial and Countrywide Financial. The interest rates charged to borrowers rose as FICO scores fell (a lower FICO score signals higher risk), as we would expect if a competitive market worked effectively in matching loan price to borrower risk characteristics. According to Inside B&C Lending, "on average, borrowers in the lowest FICO range paid 272 basis points more than those at the upper end of the credit scale." Similarly, in at least one lender's securitized portfolio, borrowers with lower debt-to-income ratios paid lower mortgage rates. Specifically, 8.4% of borrowers in one pool had debt-to-income ratios of 20% or less. These borrowers paid an average fixed interest rate of 6.42%. At the other end of the scale were 4% of borrowers who had debt-to-income ratios in excess of 50% at the time of origination. These borrowers paid an average interest rate of 7.46%.