Understanding Risk-Based Pricing and How It Affects Your Mortgage Rates

When it comes to securing a mortgage, understanding the concept of risk-based pricing is crucial. This method is used by lenders to determine interest rates and other loan terms based on the applicant’s creditworthiness. At O1ne Mortgage, we aim to provide you with the best possible terms, and understanding how risk-based pricing works can help you secure a favorable mortgage rate. If you have any questions or need assistance, feel free to call us at 213-732-3074.

What Is Risk-Based Pricing?

Financial institutions, including mortgage lenders, offer their products to a wide range of consumers. However, because no two borrowers’ credit profiles are the same, it doesn’t make sense for lenders to offer the same terms to everyone. Risk-based pricing allows lenders to offer financing options to more borrowers while ensuring they’re properly compensated for the risk each one presents.

When you apply for a mortgage, the lender will assess several factors, such as your credit score, credit history, income, and other debts, to estimate how likely you are to repay the loan on time. The more likely you are to keep up with your payments, the better terms you’ll get.

How Risk-Based Pricing Affects Your Interest Rates

In general, you can expect to secure a lower interest rate if your creditworthiness is strong because it means you’re more likely to repay the debt as originally agreed. Conversely, if you only barely meet the lender’s minimum eligibility criteria, you can expect to pay a higher interest rate.

For example, here are the average interest rates for new auto loans based on credit score range, according to Experian’s third-quarter 2023 State of the Automotive Finance Market Report:

• Super prime: 5.61%
• Prime: 6.88%
• Near prime: 9.29%
• Subprime: 11.86%
• Deep subprime: 14.17%

In addition to the interest rate, your creditworthiness can also impact a loan’s fees and your repayment terms.

How Lenders Determine Your Creditworthiness

Risk-based pricing isn’t a perfect method because having a low credit score doesn’t automatically mean that you’re bound to default on debt payments. However, credit scores and other elements of creditworthiness provide lenders with enough predictive power to get a good idea of your odds of paying on time. Here are some of the factors they look at:

Credit Scores

Your credit score is a three-digit number that represents a snapshot of your overall credit health. When you apply for a mortgage, the lender will obtain your credit score based on one or more of your credit reports. If your credit score is below the lender’s minimum requirement, you may be denied.

Debt-to-Income Ratio

You don’t necessarily need to have a high income to get approved for a mortgage, but your debt-to-income ratio (DTI) must be in a reasonable range. Your DTI is calculated by dividing your total monthly debt payments by your monthly gross income. For instance, if you earn $60,000 per year and have the following monthly debt payments:

• Student loans: $300
• Auto loan: $350
• Mortgage: $1,300
• Credit card minimum payment: $50

Your total monthly debt obligation is $2,000, and your monthly gross income is $5,000, giving you a debt-to-income ratio of 40%. Most lenders require you to have a DTI below 50%, but some may go even lower than that.

Other Credit Report Items

Your credit score can give lenders a good idea of how you’ve handled credit in the past, but it doesn’t provide the full story. As a result, lenders will usually run a hard inquiry on one or more of your credit reports to look for red flags. More specifically, they’ll look at items such as:

• Delinquencies
• Collection and charged-off accounts
• Bankruptcies
• Foreclosures and short sales
• Recent credit inquiries

If you have any of these on your credit report, it could result in a higher interest rate or a denial. But over time, new positive information can help outweigh old negative information. Even then, it’s wise to get caught up with payments and pay off any outstanding collections.

How to Improve Your Chances of Getting a Lower Interest Rate

Risk-based pricing protects lenders from losing money on their investments, but it’s not ideal for consumers without a solid credit profile. While you may get approved, you could end up paying hundreds or even thousands of dollars more in interest charges compared to someone with stellar credit. Here are some steps you can take to improve your odds of getting favorable terms:

Get a Cosigner

A cosigner is a person who agrees to make loan payments in the event that you no longer can. If you have a cosigner with great credit, the arrangement reduces the risk of default, incentivizing the lender to offer you better terms. Just keep in mind that not all lenders allow cosigners. Also, be sure to communicate with your cosigner about their responsibility and the potential impact the loan or credit card can have on their credit options.

Pay Off Debt

If you have one or more credit card or loan balances that you can pay off relatively quickly, eliminating them can lower your DTI. Even if you can’t pay off a credit card balance in full, reducing the balance can cut your credit utilization rate, which can potentially improve your credit score. If you have multiple debts you want to pay off, consider using an accelerated repayment strategy like the debt snowball or debt avalanche method to maximize your effectiveness.

Shop Around

In some cases, you can avoid getting a high interest rate offer just by knowing upfront what credit profile the lender requires and the terms it offers. For example, most major credit card issuers charge high interest rates on all of their rewards credit cards despite requiring good or excellent credit to get approved. But if you go to your local credit union, you may be able to get a lower rate without having perfect credit. Also, while some personal loan companies prefer higher credit scores, others might be more willing to lend to you if you have poor or fair credit. Do your research before you apply to make sure you have the right lender.

Improve Your Credit Score

If you don’t need access to credit urgently, review your credit report and look for opportunities to increase your credit score before you apply. As previously mentioned, one option is to pay down credit card balances. Other options include getting caught up on past-due payments, limiting how often you apply for credit, and asking a loved one to add you as an authorized user on their credit card account. You can also look for inaccurate information on your credit report. If you find something you don’t recognize, you have the right to file a dispute with the credit reporting agencies. Finally, consider using a free feature like Experian Boost® to get credit for on-time payments that aren’t typically included in your credit report. This includes payments for things like rent, utilities, cellphone, insurance, and even some streaming subscriptions.

What Happens if You Get Unfavorable Terms

If a lender gives you less favorable interest rates or other terms than other borrowers based on information it found in your credit report, it’s required by law to provide you with one of the following notices:

• Risk-based pricing notice: Lenders provide this notice to a borrower after the terms of the loan or credit card have been set but before the borrower accepts them. Lenders can provide it in writing, electronically, or verbally.
• Credit score disclosure exception notice: This letter, which lenders can provide electronically or in writing, shares the borrower’s credit score and the score distribution for the loan or credit card.

These notices may also share information about how to get a copy of your credit report, as well as your credit score and the negative factors affecting your credit score. With a credit card, your account is typically opened upon approval, so you can’t change your mind if you end up with a high interest rate. But if you’ve applied for a loan, you’ll typically be able to review the loan terms before accepting them. If you don’t like what you see, you can reject the offer and either apply elsewhere or work on improving your creditworthiness before reapplying.

The Bottom Line

The best way to get a low interest rate on your next mortgage is to improve your creditworthiness. Check your credit score and credit report to get an idea of what you’re working with and some clues on your next steps. Once you’re ready to apply, shop around for a mortgage matched to your credit profile and consider some of the strategies listed above to improve your chances of securing favorable terms. At O1ne Mortgage, we’re here to help you every step of the way. Call us at 213-732-3074 for any mortgage service needs, and let us assist you in securing the best possible terms for your mortgage.