2-2-18: What is “tiered” pricing
Question of the week: What is “tiered” pricing?
Answer: There are several axioms in economics, the two most well-known are that supply and demand determine prices and that the greater the risk the greater the return. Both of these axioms determine your mortgage interest rate. Rates in general are determined by supply and demand for mortgages as investments, your rate in particular is further determined by risk. When pricing your mortgage we put several factors into the pricing software and it filters through those factors and returns with the price for your particular circumstance.
Tiered pricing is used by lenders to adjust for risk, the riskier a loan the higher the rate. What creates risk in a mortgage? Several factors create risk; the most important ones are occupancy, loan to value and credit history as represented by credit score.
Tiered pricing comes into play in two different ways. First, the tiers added to a loan price for some of the factors mentioned above, these “add-ons” are standard pricing adjustments on conforming loans from Fannie Mae and Freddie Mac or if a jumbo loan from whomever the investor may be.
Let’s take an extreme example. A borrower obtaining a $400,000 loan for the purchase of a condominium as investment with 20% down and a 711 FICO score will have different pricing than someone obtaining a $400,000 loan for the purchase of a condo as their primary residence with 30% down and a FICO score of 798.
Taking a look at our non-owner occupied transaction with a condo as the property type. The following add-ons occur to the price of the loan (one point is equivalent to 1% of the loan amount, in this case one point is $4000):
Investment property = 3.75 points
Credit Score = 1.25 points
Condominium = 0.75 points
Total add-ons = 5.75 points
What if the borrower put down 30% and purchased a condo but for owner occupancy? Because of the change in risk the add-ons, or tiers, change:
Credit score = 0.500 points (as opposed to 1.25%)
No add for being a condo
No add for investment
Total add-ons = 0.500 points
What if the borrower put down 30% purchased the condo for their primary residence and had a 799 credit score? Essentially there are no add-ons and the price of the loan would be the same if the borrower were purchasing a detached single family home.
As you can see in the first scenario with 20% down the cost to the investor is $21,000 more in the cost of the loan than the second scenario where the borrower will have 30% down and live in the property. (5.75 points = $23,000 less 0.50 points or $2,000).
Surely an investor is not going to pay $23,000 more in loan fees out of pocket. This is where the second part of tiered pricing comes in. When speaking about mortgages there is a trade off between the cost you can pay and the rate you can pay. Observe:
The teeter-totter above has the price of the loan on one side and the interest rate on the other side. If you want a lower rate then you will pay a higher price for the loan, if you want a lower price then you pay a higher rate for the loan. In our example above, the investor could get a rate of 4.25% and pay the 5.75 points for the loan, or could get an interest rate of 5.25% and pay only one point for the loan. His payment is higher by $242 per month ($1967 at 4.25% vs. $2209 at 5.25%) if he takes the higher rate, but he saves $19,000 in points.
The same scenario on a smaller scale occurs when you are purchasing your home. The you can reduce your cash to close by taking a higher interest rate, the rule of thumb is usually 0.125% in interest rate will reduce your costs by approximately one-half point (0.500%).
Using the $400,000 loan example for a primary residence, today our conforming rate for owner occupied purchase with 20% down and 740 credit score at cost of 1.25 points is 4.125%. The payment is $1939 per month and the loan cost is $5000. However, if you take a rate of 4.25% the cost will be 0.75 points, your payment goes up to $1968 ($29 per month) but your cost goes to $3000, a savings of $2000 in cash to close. If you took the lower rate and put the $29 saved per month in a coffee can it would take you almost six years to save the $2000 you would have saved at the time of your transaction had you taken the higher rate. Of course if you did take the higher rate after six years your total cost to purchase the home would be higher by $29 per month.
The question you need to answer is do you need the $2000 more today than you need $29 each month in the future?
What is tiered pricing? On one-hand it determines the price of your loan based on certain risk factors. On the other hand it allows you to trade more or less cash to close your transaction with a lower or higher monthly payment.
Confused? If so please do not hesitate to contact me to discuss your situation and rate options available for your purchase or refinance transaction.
Have a question? Ask me!
A couple of very important economic data releases this week. On Monday the Bureau of Economic Analysis released personal income, saving and spending data for December as well as the price index. There a bit of good and a bit of not so good in the report, with the good outweighing the not so good in impact on mortgage rates. Incomes increased a solid 0.4% in December against a price increase of only 0.1% (0.2% if food and energy taken out). The increase in income is very positive for economic growth and puts upward pressure on rates. Also putting pressure on rates to go up was a 0.4% increase in consumer spending following a revised 0.8% increase in spending in November from October. As consumer spending is approximately 65-70% of our economy increases point to stronger economic growth. The price index change is lower than expected at this stage of economic growth and a bit of downer in the report, and positive for rates. However, of greater concern was a drop in consumer saving to 2.4%, the lowest rate in thirteen years. While greater consumer spending is helpful for the economy, it is not very helpful if the increase is based on consumers dipping significantly into their savings for their purchases. Overall the report results are not positive for lower mortgage rates.
On Wednesday the Fed Open Market Committee—the group that determines what rates the Fed will charge member banks—announced no rate increase in January. This was entirely expected by everyone who follows the Fed and rates so no surprise mean no impact on rates. In the announcement the Fed indicated it feels inflation will increase to 2% at some point this year and stabilize at that level. “Solid” was how the FOMC described employment and business spending. The announcement gave no reason to expect the Fed will not continue with its plan to raise rates three times in 2018, and the expectation is for a 0.25% increase in each hike. Should inflation and employment heat up further we could see a fourth hike added this year, or perhaps one of the hikes being 0.50% instead of 0.25%.
Strong, solid, very positive, all describe the employment report released this morning by the Labor Department. Non-farm payrolls increased 200,000 in January, following a revised 160,000 increase in December. The unemployment level remains at 4.1% and the participation rate is level at 62.7%. Average hourly earnings were another sign of strength in employment showing a 0.3% increase for the month and up 2.9% from January 2017. With the price index increasing 1.7% the gap between hourly pay increases and higher prices being over 1% is certainly good news for workers as their paychecks go further this year than last. The soft spot in the report is a decline in the average workweek from 34.5 hours to 34.3 hours. This is the first decline in sometime for the average workweek so it could be a one-off due to winter weather that impacted most of the country in January, we will see what next month’s report has to report to see if this is a negative and concerning trend. Overall the strength of new hires and higher wages are very positive and negative for mortgage rates.
Rates for Friday February 2, 2018: Conforming rates increase for the second week in a row and third time in four weeks and high-balance rates are up for the fourth Friday in a row. The positive economic news and growing momentum will continue to put upward pressure on rates. Lock in your rate when you can remains the advice from this mortgage expert.
FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS:
30 year conforming 4.1215% Up 0.125
30 year high-balance conforming 4.375% Up 0.125%
Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.
Two weeks ago I wrote in this space how excited I was that the Philadelphia Eagles were playing in the NFC Championship. That excitement is more than doubled as they play in the Super Bowl on Sunday. This is their third trip to the Super Bowl and they are looking to win it for the first time (losing 27-10 to the Raiders in Super Bowl XV following 1980 season and 24-21 in Super Bowl XXXIX to Tom Brady and the Patriots following the 2004 season). The last time the Eagles won a championship was in 1960, so the fans could be described as long-suffering.
As is my hope with all big games, and little ones, my hope is that it is well played and determined not by one team playing poorly and making mistakes but by one team playing exceptionally well and deserving the victory. My bigger hope is that victorious team has millions of fans signing their fight song well into Sunday night. The same song that has been my ringtone for the past several weeks.
Fly Eagles Fly!
Dennis
