Mortgage Credit and the Evolution of Risk-Based Pricing

BABC 04-23: Mortgage lenders have long used credit scores as a basis for estimating borrower risk. This risk differentiation is reflected in the coupon rate of the loan. In this study we examine the relationship between FICO scores and mortgage coupons to measure how effectively risk-based pricing has been used and to determine the dollar value of a favorable FICO score. Our analysis shows that there is a significant relationship between FICO scores and coupon differentials although this relationship is not linear. That is, the penalty for being a weaker-than-average credit is greater than the benefit of being a stronger-than-average credit. We find that risk-based pricing has become more rational since 1998. The data show a trend towards greater differentiation in mortgage coupons over time. This reflects the improved efficiencies in differentiating along the credit spectrum…