Solano Real Estate Scene: What is risk-based pricing?
The rich are getting richer and the poor are getting poorer.
One of the primary reasons for this is risk-based pricing in the credit industry and a lack of financial literacy education in our schools.
Much has changed over the past 25 years in the real estate industry with the evolution of the internet and artificial intelligence, but one of the most significant changes has been the credit quality grading system that mortgage and PMI companies use to determine the rate they offer buyers and borrowers.
Nearly every mortgage loan in the country in 1995 was approved or denied by a human being without any artificial intelligence program analyzing the borrower’s financial statement, loan application or credit scores.
Now, credit scores like FICO and Fannie Mae’s Desktop Underwriting system, called DU, and Freddie Mac’s Loan Prospector, LP, are almighty powerful for more than 99 percent of all credit decisions. The human underwriter simply validates the automated loan approval by meticulously reviewing the loan application, the assets and income verification to ensure the artificial intelligence system wasn’t given incorrect or fraudulent data to make the credit decision. The human underwriter has the final say and signs off on nearly every mortgage loan in America.
DU, LP and FICO determine the level of risk.
If a first-time homebuyer was buying a starter home in 1995 with 5 percent down and the 30-year fixed rate loan was approved, the PMI cost and interest rate would be the same for a 680 FICO score and a 780 FICO score.
Today, it is like auto insurance where premiums are based on DMV driving records. The more moving violations a person has, the higher the premiums. The 780 FICO score-approved individual buyer in January 2020 can obtain a 30-year fixed rate mortgage at an estimated rate of 3.75 percent with a 1 percent loan origination fee with a PMI cost of 0.38 percent annually, while the 680 buyer would be offered 4.25 percent with the same 1 percent fee and the PMI cost of 0.96 percent.
The 680 score buyer might have five times as much money in the bank and in assets and might have a much higher income and lower debt ratio than the hot-shot 780 score borrower and may have never had any derogatory credit ratings. The mortgage rate and PMI cost would be higher for a 679 FICO score buyer than the 680 guys.
This is frustrating and may sound very cold, but it is what it is and it ain’t going away. For now, pricing for mortgages, PMI, auto loans, credit cards and personal loans are almost always priced based on FICO or one of the many other scoring systems that exist in the market today.
The 740 FICO rich, which I consider upper middle class folks who are on a path to financial independence and security at retirement, need to help the poor, which I consider a majority of the population that needs to get on the rich person’s path in America, and educate them on how to have and maintain the highest scores possible.
A strong middle class is critical to the American dream and a strong middle class that can someday retire with financial security is critical to what I call the “rich” because otherwise the 10 to 20 percent of the population that will retire financially secure in 2030 and 2040 will have to pay for the 80 percent of the population that isn’t secure.