Breaking Down Credit Score & Mortgage Rates
History has shown that the best way to predict a person’s behavior over the near-term future is to look at that person’s behavior in the recent past. It’s a concept similar to the First Rule of Physics — an object in motion tends to stay in motion.
This basic concept applies itself to predicting an individual’s spending habits as well. Precedent shows that a person who regularly pays their bills will continue to pay their bills on time in the foreseeable future. Your credit score therefore is based upon a person’s predicted spending habits based upon past performance. Specifically, to mortgage lenders, your credit score is your probability that you will pay your mortgage on time for the next 90 days. Higher credit scores correlate with lower risk. Transversely, low credit scores are associated with a high risk and that is why lower credit scores receive a higher mortgage rate.
Mortgage lenders use a credit model known as FICO. It is your FICO score that impacts the mortgage rate a person is eligible for. FICO is paired with the newly implemented LLPA (Loan-Level Pricing Adjustment) that was put in place due to the major mortgage market losses in 2008. LLPA are ‘discount points’ applied to a mortgage rate based upon the borrower’s level of risk. Here is an example:
Assuming a 20% downpayment, look at how discount points change based on credit score. Fees get massive for FICOs under 700.
740+ FICO : There are no discount points required. This loan is “low risk”.
720-739 FICO : 0.250 discount points are charged to the borrower, or $250 per $100,000 borrowed
700-719 FICO : 0.750 discount points are charged to the borrower, or $750 per $100,000 borrowed
680-699 FICO : 1.500 discount points are charged to the borrower, or $1,500 per $100,000 borrowed
660-679 FICO : 2.500 discount points are charged to the borrower, or $2,500 per $100,000 borrowed
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